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A poster displays Iranian missiles in a street in Tehran, Iran. File photo: MAJID ASGARIPOUR//WANA/REUTERS
A poster displays Iranian missiles in a street in Tehran, Iran. File photo: MAJID ASGARIPOUR//WANA/REUTERS

Initial indications are that financial markets have virtually shrugged off the two unprecedented drone and missile attacks between Israel and Iran, with investors more preoccupied with the fading likelihood of a rate cut in June. 

As expected, Israel counterattacked Iran on April 19, sending drones and missiles to Isfahan, a significant target because it’s where Iran’s nuclear facilities are situated. Israel hasn’t taken official responsibility, but the attack is widely viewed as a retaliation to Iran’s unprecedented direct airborne attack on the country earlier in the week. 

Iran launched the first-ever direct attack on Israel in response to Israel bombing what Iran describes as a diplomatic building in Syria, killing senior Iranian military commanders. It was seen as a revenge attack because it forewarned countries that it was sending 300 drones and missiles to Israel, enabling allies to disarm them before they got to Israel. 

These tit-for-tat attacks should be viewed as largely symbolic rather than true escalations in the conflict that could pave the way for a full-blown war between the two countries. That’s not to say the Gaza Strip invasion, the proxy war between Israel and Hezbollah, and these latest attacks, could not result in the complete destabilisation of the Middle East.

Were this worst-case scenario to transpire, the economic and financial market fallout would be considerable, but it’s still not the most likely scenario. The gold price has benefited from its safe-haven status, rising to a record intraday high of $2,417 on April 20, but has since declined to $2,360/oz.

Oil prices would be most directly affected from a more prolonged war because of the sheer quantity of oil produced in the region. Substantially higher oil prices would put upward pressure on inflation when we least need it, adding to the effect of rising oil prices already being felt by consumers this year. Ultimately, a war would also severely disrupt the anticipated slow and steady growth this year, possibly resulting in recession.

To date though, the effects of the hostilities on the oil price have been muted, particularly given that the price has already been rising since the beginning of 2024, when it was trading at about $75 a barrel. In the wake of the attacks Brent crude peaked at $91.30 on April 18 and is now trading at $88.20.

The latest US inflation data highlights the effects of the higher oil price on the consumer price index, which came in higher than expected at 3.5% in March. Half of the monthly increase was attributed to fuel and rental costs. This week, the US Federal Reserve’s preferred inflation index, the personal consumption expenditures price index, is due to come out and is also expected to rise because of higher energy prices.

Any further increases in oil prices would put central banks’ inflation achievements over the past year at risk. Though inflation rates have come down substantially from their highs of around 10% in developed countries, the US inflation rate is still not close enough to the Fed’s target of 2% to justify a rate cut. Thus, investors no longer expect a June rate cut, meaning the three hoped-for rate cuts are unlikely to materialise in 2024. 

Absorbing this disappointing news, stock markets had a tough week, declining 3%. The sell-off is being attributed to the combination of the deteriorating interest rate sentiment and the Middle East tensions. Though the stock market did decline in response to the attacks, the sell-off was not significant enough to suggest that the events in Iran and Israel overly rattled investors, and sentiment appeared to bounce back at the beginning of the week. Thus, we are relatively calm at this stage, viewing these events as shows of power by the two countries rather than calls to war. 

Much will depend on the future trajectory of geopolitics and the different agendas likely to influence the Middle Eastern situation. Our research indicates that US president Biden is effectively hamstrung. The president has lost ground in the polls largely because of how he has handled the Israel-Palestine invasion. Thus, the US is likely to err on the side of restraint, urging Israel to de-escalate tensions and unlikely to participate in the hostilities. 

Meanwhile, Russia arguably stands to benefit most from the war in the Middle East and is thus likely to incite further militancy between Iran and Israel strategically. President Vladimir Putin would prefer to see Republicans win the elections because he believes that under a Donald Trump presidency Ukraine would likely receive less aid and tensions within Nato would probably increase. 

China is likely to remain on the fringes of any Middle Eastern conflict. The world’s second-largest country doesn’t stand to benefit from a war. It relies heavily on Middle Eastern oil and would be adversely affected by a possible oil shock. However, our analysis shows that China will maintain its special relationship with Iran without getting involved in a war.

Though the risks of further steep escalations in hostilities seem unlikely right now, there’s no escaping from the fact that an unanticipated attack that leads to the onset of a real, rather than symbolic, war between the two countries would heavily affect the economy and financial markets. 

Against this backdrop investors may be tempted to increase their cash holdings significantly. But we recommend maintaining a geographically diversified portfolio across cash, bonds, and equities, investing in quality companies that would be equipped to ride out any economic adversity arising out of an escalation in geopolitical risks.

• Kadikoy is managing partner of Levantine & Co, an independent offshore investment management firm.

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