Navigating financial markets amid US-Iran tensions

US-Iran tensions appear to be de-escalating for now, but the situation is likely to remain volatile. While rising geopolitical risks can trigger bouts of short-term volatility, investors should not ignore the recent improvements in selected economic indicators and earnings. Should the nascent recovery in the global economy continue, further upside in global markets is still possible. As such we remain cautiously optimistic.

Following the killing of Iranian military leader Qassem Soleimani on January 3 by a US drone strike, Iran has launched more than a dozen ballistic missiles at US forces in Iraq in a marked escalation in the confrontation between the Washington and Tehran.

Both parties would logically like to avoid a full-blown war. For one, the Iranian economy has been crippled by US sanctions and the broader global slowdown. According to the IMF, the economy likely contracted by 9.5% in 2019. As the regime struggles with economic isolation, the IMF expects unemployment to rise above 18% in 2020. This coupled with high inflation (27.8% 1) and the authorities’ recent decision to increase petrol prices by more than 50% in November, had sparked days of domestic protests.

Meanwhile, President Trump’s odds of re-election may be hurt if the uncertainty arising from further escalation ends up jeopardizing the US economy. Following the Iraqi invasion in 2003, former US president George Bush’s approval rating first soared and then fell as the US economy subsequently faltered. Former US president Jimmy Carter’s election troubles in 1980 also stemmed from earlier conflicts with Iran.

Yet, as emotions run high, further escalation cannot be ruled out. Afterall, given Soleimani’s reported popularity as a leader, the Iranian government would be hard pressed to present an adequate response. It could also potentially help the regime rally domestic support and distract the populace from the current economic woes. The Iranian leaders may also believe that the regime may come out stronger from limited US airstrikes. President Trump on the other hand, may choose to ignore the lessons from history and adopt a more aggressive stance to maintain the credibility of his threats against Iran in order to counter impeachment pressures and secure a second term in office.

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Implications for markets

The multiple factors and considerations above present a volatile stage for financial markets at the start of 2020. Increased risks to US and global growth and a marginally higher likelihood of a Democrat presidency are potentially negative for risk assets. Iraqi instability may also disrupt its 3.5 million barrels of daily oil production, resulting in higher oil prices. Geopolitical concerns are likely to remain heightened and result in near-term volatility in risk assets even if diplomatic channels between US and Iran are explored.

That said, at the point of writing, tensions appear to be de-escalating, as President Trump has signalled that he would not respond militarily to Iran’s attacks on American forces in Iraq. At the same time, investors should not ignore the recent improvement in the global PMI manufacturing indicator and earnings revisions in the Emerging Markets. Besides, the already-muted growth expectations in Asia should mitigate the risk of a further downward adjustment, while signs of a bottoming of the technology cycle are likely to provide some buffer. Meanwhile, the Chinese authorities continue to boost its economy as seen from the latest cuts to its reserve requirement ratio. The build-up of oil reserves in China, and generally muted demand-side inflationary pressures, should also help shield the region from the impact of an oil price spike. Likewise, the upcoming “phase one” trade deal between the US-China later this month should help to stabilise global trade.

Even the economic data from Europe has been beating expectations, albeit from highly depressed levels. Barring an aggressive and extended escalation, the global economy should continue its nascent recovery.

We remain positive on equities but have recently pared back some of our exposure given the (earlier) excessive optimism in the market. With bonds, we remain cautiously positive on carry plays, such as Asian credits and currencies. Further, risk-free rates are likely to remain low amid these uncertainties and this will likely encourage yield-seekers, with investors more inclined to fade the risk-off trade.

As markets remain volatile, high quality bonds can help to stabilise portfolios, as would low volatility equity strategies. Equity dividends in Asia, which have historically been more stable than earnings, are also likely to be remain a welcomed feature in investors’ portfolios.

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Sources:
1 Trading Economics. December 2019.

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