After the U.S. killing of Qassim Suleimani on Jan. 3 and Iran’s retaliatory, non-lethal missile strike against two U.S. military facilities in Iraq on Jan. 7, the situation appears to have de-escalated. However, investors continue to worry about the potential for this conflict between the U.S. and Iran to worsen. We do not believe that a war is likely at this juncture, but it is important to understand the potential effects that such a worst-case scenario could have on the markets.
War has usually led to a bear market …
Historically, serious military conflict has been one of the more reliable triggers for an equity bear market in the past hundred years. Our team has analyzed various factors that have contributed to bear markets since 1915,1 and there has been a high historical correlation with times of war. There were 28 equity bear markets between 1915 and 2018. War wasn’t a factor in all of them (only about 30%). But, when war was happening in the world, a bear market followed about 80% of the time – higher than other factors such as recession, rising unemployment, an inverted yield curve, and rising inflation. In other words, war isn’t a necessary condition for a bear market, but it has historically been enough to trigger one.
This has been especially so for conflicts in the Middle East that threaten oil supplies (a sharp rise in oil price affects business and consumer spending, compounding the economic damage). A case in point is the Yom Kippur War of 1973, which resulted in a major rise in the price of oil and a crushing of the global economy and stock markets.
… but stocks have tended to rebound relatively quickly
However, there is more to the story. In a similar analysis, we looked at equity performance for six of the wars during this timeframe (World War I, World War II, the Cuban Missile Crisis, the Yom Kippur War, the Kuwait War and the Iraq War).2 We found that the U.S. stock market typically bottomed within 12 months of the tension becoming apparent (which was usually before the outbreak of war), and, most importantly, typically returned to its pre-conflict level within 18 months.2
Additionally, we think it is worth pointing out that the world today is not as dependent upon Middle Eastern oil for energy as it has historically been, given the dramatic increase in oil production from the U.S. What’s more, the global economy is less dependent on oil in general – it is just less energy intensive than it was just a few decades ago. That could also mitigate any negative economic effects resulting from a major conflict between the U.S. and Iran.
What could continued U.S.-Iran conflict mean for investors?
And so, as news flow around the U.S.-Iran conflict continues, we should be prepared for the possibility that the situation may worsen. If it does, we would expect to see an impact on various asset classes. In our view:
- A sell-off in risk assets would be likely, especially the stocks of energy-intensive companies and markets in the Middle East.
- We would likely see “safe haven” asset classes such as gold, Japanese yen, Swiss franc, and U.S. Treasuries perform well.
- Although the world is less energy-dependent on the Middle East, we would still expect to see a significant rise in the price of oil (and related energy commodities) and relative outperformance of sectors such as oil & gas and utilities (many of which have tariffs related to wholesale energy prices).
- Among factors, we would expect low volatility stocks to outperform during periods of risk aversion.
- Among emerging markets, energy users (such as China and India) would likely underperform non-Middle East energy producers (such as Russia and Mexico). The Russian stock market has been cheap (with dividend yield exceeding price-to-earnings ratios) and is heavily weighted in energy sectors, suggesting significant potential to benefit.
- The Russian ruble and Mexican peso could also benefit for the reasons mentioned in the previous bullet point.
- Finally, we could see U.S. high yield bonds holding their ground. This asset class could be hurt by heightened risk-aversion, but it has a significant weighting in the energy sector, which could help it.
It is worth noting that the Federal Reserve has a very accommodative stance, as do many major central banks. That should help render any risk asset sell-offs shorter and shallower.
In summary, we suspect tensions between the Iran and the U.S. will continue but remain contained, and we believe an actual war is highly unlikely at the moment. However, it’s always good for investors to be prepared. Thus, it’s important to remember both the market implications of past wars and Middle East conflicts, as well as the ways in which the world has changed since then.
With contributions from Tomo Kinoshita, Global Market Strategist for Japan.