Last night, Israel attacked Iran’s territory directly. This is the second major escalation of what has been a mostly covert international confrontation between Israel and Iran. But now, Iran has launched an attack on Israel from its territory and vice versa. Luckily, the limited nature of the Israeli attack appeared to avoid a major, indiscriminate attack on population areas from Iran.
The world is on edge in the wake of the unprecedented confrontation that will redefine the rules of the modern Middle East, regardless of some silver linings suggesting that both Israel and Iran want to avoid all-out war. Of course, the desire to avoid conflict doesn’t necessarily mean it will be avoided. From the perspective of investors, though, we must evaluate these highly emotional and troubling events through a financial lens.
We must coldly evaluate how the extraordinary events of our time will affect the economy and the assets we depend on for our future prosperity. For several reasons, I suspect the effect of the current events will be limited on the global economy compared to the Arab-Oil Embargo following the Yom Kippur War.
One of the factors that has defined the confrontation between Iran and Israel so far has been the fact that the two countries are not geographically contiguous. This means that the conflict is often fought in or over the territory of the countries that lie between the two belligerents.
The low-intensity conflict that has been brewing between the two nations for the last four decades has the potential to ratchet up in intensity now that confrontation between the organized militaries of each state has occurred. But ultimately, the distance creates a certain limit on the kinetic options of both sides.
A new math of deterrence is developing between the two sides. Israel has conventional military superiority, but Iran has built ominous capabilities along its border, like the tens of thousands of rockets that could be unleashed by Hezbollah. But these facts of deterrence may create more stability than many uninformed observers would think from the headlines lately.
America is in a unique role. It is discouraging escalation between the two sides, and it is trying to bring Israel’s campaign in Gaza to an end to reduce Iranian justification for escalation. America not wanting to participate in hostilities severely limits what Israel can do. While Israel has the superior military capability, among the world’s best, it is a nation with less than one-tenth the population of Iran.
Furthermore, many Americans may not understand the deep cultural divide between Persians and Arabs. One extension of this reality is that most of the “Persian Street” is simply not thrilled about an armed conflict that could significantly interrupt economic life, already strained by the theocratic government, for an issue that isn’t even close to the forefront of Iranian popular consciousness.
Similarly, many in Israel are growing wary of escalating what could become a three-front war that appears to be alienating their most important strategic partner. So, luckily, currently, there appear to be moderating forces, both external and internal, that are allowing cooler heads to prevail. Iran has signaled that it will not respond to Israel’s very limited attack last night.
The presence of two aircraft carrier groups in the region should set a ceiling on what Iran is willing to subject Israel to, despite the nation’s tough talk. Israel’s small-scale attack last night, like Iran’s before it, appears to be designed to be negligible enough to avoid the type of catastrophic response and escalation spiral that reasonable human beings fear most.
The Israeli attack last night appears to be following a new low-tempo pace of the conflict that has existed in border areas under dispute for years, a tit-for-tat, eye-for-an-eye response that attempts to avoid a full-scale escalation into a conflict that would be equally devastating to both sides. One thing I always find useful in understanding foreign policy in a way that transcends the sensationalized coverage of very scary events is to remember what unites us universally as human beings.
One thing that no human being likes to see is hellfire raining from the sky. Ultimately, given the geographic separation, the path of any conflict between Israel and Iran likely means escalated air campaigns. But both Israel and Iran are limited in their capacities, and both have militaries that are designed primarily for the confrontation of geographically contiguous threats. Several changing dynamics in the Middle East bear greatly on this conflict:
- Syria’s Assad regime was propped up in the recent bloody Civil War by Tehran, and the ruling Alawite class is Shi’ite. Militia in Syria and Iraq are a key lever Iran has to pressure Israel, along with the more publicized ones in Lebanon.
- Both the Iranian and Israeli populations are primarily composed of normal people, just like you and me, and normal people don’t want hellfire raining from the sky. As simple as it seems, this will be a compelling check on the more truculent and radical elements in both the Israeli and Iranian governments.
- Iraq is a U.S. military ally, despite having some factions aligned with Tehran. US interest in the Middle East is very much aligned with promoting a continued dĂ©tente between Israel and its Arab neighbors. For instance, Jordan, which was an adversary of Israel in the past, helped Israel shoot down Iran’s aerial attack.
- Iran will likely be able to obtain a nuclear weapon in the coming years. The nuclear weapons program has evolved to a stage where it likely could not be eradicated with military action. Iran has recently said it will pursue weapons development if its nuclear facilities are attacked.
All the factors are modern drivers of the delicate and rapidly evolving strategic situation in the Middle East. However, it’s important to remember that this isn’t 1974. The Arab states have so far proven remarkably loyal to the economic dĂ©tente that was developing before October 7th, and both Iran and Israel have ample reasons to avoid the type of conflict that would cause widespread economic disruption. One thing that should give an idea of what’s going on behind Iran’s poker face is that the regime sent out reassuring messages when its citizens began to line up outside gas stations.
Risks and Where I Could Be Wrong
A miscalculation in geopolitical events causing far worse outcomes than anyone could imagine is well understood in the popular consciousness. Everyone knows that the logic that the war will be over by Christmas, is often flawed. And you only need to read The Guns of August to understand how optimism in the face of the inherent uncertainty associated with military confrontation is the epitome of hubris. War is inflationary, and the return of inflation is a major risk that is especially in focus.
Still, I think it’s important to distinguish from the type of high-intensity conflict going on in Ukraine, which is much more similar to those World War I days, and the type of low-intensity conflict that is the typical playing field between Israel and Iran. Unprecedented actions have the potential to upset this balance and make the consequences of the Iran/Israel conflict far more inflationary than in the past, more similar to after the Yom Kippur War. If Iran blockades the Strait of Hormuz, it could cause global energy prices to skyrocket.
Another major source of risk is the rising cost of U.S. debt service. Not only can this crowd out private sector activity if rates stay higher, a fact which seems assured after Fed Chair Jerome Powell’s recent comments, but they can also eventually take away from the incredibly high levels of U.S. military spending that, I think, is a major lynch pin of global economic stability. Furthermore, any of the below economic risks could derail the market.
- Fed policy error.
- The banking crisis worsens.
- Return of inflation.
- CRE meltdown.
- Write-downs of private assets.
- Increased political risk during an election year.
Overall, I think the market has priced the risks pretty accurately. Given the recent pace and breadth of the sell-off and the fact that pairwise correlation should go down during earnings season, I think we should see a relief rally in a tactical sense. The elevated put/call ratio is a contrarian positive in my opinion.
Conclusion: Putting Geopolitical Risk Into Context
The events in the Middle East are upsetting, highly risky, and could certainly boil over at any moment. But from a market perspective, it’s just another day at the office. It is critical to remember the saying that markets climb a wall of worry and fall on a slope of hope. The market is also sage at times, as a result of the collective inputs sometimes facilitating the wisdom of crowds to make itself known.
As the significant chart from Carson Investment Research above shows, the market does not necessarily respond to geopolitical risk in line with the emotional experience associated with geopolitical risk. For example, the market responded in a very muted fashion to the Cuban Missile Crisis. Certainly, in a much more restrained fashion than you would expect on the verge of a thermonuclear catastrophe.
I like to look at the seasonality of volatility as a key guiding factor. I recently recommended shorting the volatility index, S&P VIX Index (VIX), with put options dated in June. Furthermore, I still think these put options will expire in the money, despite recent volatility. Volatility tends to cluster, and given the rapidness of the recent volatility spike and the mitigating factors applying to the key geopolitical risk causing it, I suspect markets are in for a rally after this healthy risk-off period.