Middle East conflict: Four weeks on

Escalation risk has risen. The Middle East conflict has entered its 5th week. Events last week reduce the odds of a near-term de-escalation, in our view. Without a material shift in tone from the US or Iran, we expect oil to move higher, equities to weaken further, and the USD to remain firm.

What’s changed? The pause in strikes on energy infrastructure does not, in our view, signal true de-escalation. Houthi forces have now joined the fray while US Marines are heading to the region. A Wall Street Journal report suggests the Pentagon is considering sending a further 10,000 troops.¹ Latest data show that Iran continues to launch drone and missile strikes across the region (see chart overleaf). Prediction markets are also lowering the odds of a swift ceasefire.

Markets have remained orderly. Oil prices fell at the start of last week but ended Friday close to their 20th March level. Global stocks fell less than 2% with US stocks faring worse than many other regional markets.² UK and Japanese stocks ended the week higher, led by Materials and Energy. Credit continues to show little evidence of stress – credit spreads have not widened much. The USD index strengthened by around 0.5%.³ We think markets have remained orderly because positioning and sentiment were not overly bullish heading into March. Weakness has been concentrated in last year’s winners, suggesting investors are trimming crowded positions rather than rushing to cash.

No panic sales. Exchange-traded fund (ETF) flows through March also suggest investors remain in wait-and-see mode. March flows into most categories were weaker than in January and February but we did not observe broad outflows. Gold ETFs have seen some mild outflows, but the weakness could also reflect some central bank selling. It has been reported that Turkey’s central bank sold about $8bn (~60 tons) of gold in the last two weeks.³

Central banks pause. Market pricing for the major central banks showed marginally fewer hikes priced for the ECB and BoE compared to the previous week, while the Fed is still priced for no change this year.⁴ Inflation expectations appear to remain contained, likely balancing supply-induced higher prices against demand destruction in discretionary sectors.³ We remain unconvinced that central banks will deliver the hikes currently priced.

Fundamental supply hit will start soon. So far, markets have been driven more by sentiment than by physical supply disruption. Nations around the world have still been receiving energy deliveries that had left the Middle East before the start of the conflict. But with around ~10% of oil supply removed⁵ that situation is unlikely to persist. Deliveries will now start to slow, and some Asian nations are taking action to limit demand – Thailand has ordered civil servants to work from home and limited air conditioning temperatures and South Korean has asked its citizens to cut shower times, for example. So far, that should have little economic impact, but deeper actions may be needed in the coming weeks. This could be the catalyst for analysts to start to revise their earnings estimates lower and markets to fall further.

So what? The risk of further declines in risk assets has risen, but the private sector looks more resilient than in past crises, which should help limit the downside. The prudent response remains caution rather than conviction, in our opinion. And we keep watch for signs this sentiment shock becomes a real supply shock.

Scenarios. We update the probabilities for our four scenarios in the overleaf.

Investment risks

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