Geopolitical Events Dominate The Narrative: Energy & Off Ramps The Key Areas To Watch

Conflict in the Middle East continues to rage. First things first, it goes without saying that we hope for a swift end to hostilities, and as little harm being done as possible.

Markets, to start the week, have reached for the ‘classic’ geopolitical playbook. Crude trades higher, albeit off best levels, as a higher risk premium is priced; gold rallies amid haven demand, with the dollar benefitting from those flows too; stocks are softer as participants broadly de-risk portfolios; DM govvies soften amid higher inflation expectations on the energy price shock; while, that shock has caused losses for energy-exposed FX, such as the GBP and the JPY.

Consensus appears to have coalesced around the idea that this will be a prolonged military operation, and that both missile barrages and airstrikes will continue to be exchanged for the foreseeable future. Certainly, remarks from President Trump give little indication that the military campaign will slow in the short-term.

With that being the consensus, focus is likely to soon turn towards two bigger-picture factors, which will determine how the market trades in coming days.

Energy In Focus

Firstly, there is the matter of energy.

Thus far, the Strait of Hormuz has not been closed, per UKMTO, though shipping traffic through the Strait has reduced considerably owing to the clearly higher risk in the region, as well as a spike in insurance costs, if that insurance is even available. In the coming days, it is likely that those policies will be written, in due course, in turn resulting in traffic resuming to some degree, though in any case Gulf states were surging exports before the conflict begun. Providing that the Strait remains open, Brent at around $80bbl has probably priced enough, maybe more than enough, risk premium.

Energy infrastructure is also a chief concern. Reports on Monday morning indicate a drone strike impacting Aramco’s biggest refinery at Ras Tanura, though the situation now appears to be under control. Iran actively targeting energy infrastructure would clearly pose a substantial upside risk to crude benchmarks, as would US-Israeli strikes targeting Iranian energy infrastructure, though this latter prospect seems unlikely to come to fruition.

In any case, from a macro perspective, higher energy prices will only lead to higher inflation if they are sustained, not if moves are a ‘flash in the pan’. Furthermore, policymakers typically look-through the impact of any commodity shocks, meaning that nothing should ‘move the needle’ too much on the monetary front for now.

Off Ramps Also Eyed

Secondly, there is the matter of ‘off ramps’.

With participants, essentially, having now ‘baked in’ the idea that we will be dealing with a barrage of geopolitical headlines for some time to come, news flow suggesting the potential for de-escalation is likely to, slowly but surely, become more impactful than headlines regarding fresh kinetic action, providing that such action leaves energy infra unharmed.

At this stage, with the stated mission aim being Iranian regime change, there seems relatively little sign of any ‘off ramps’ being taken right now, though a clearer picture of how hostilities might end could become clearer as the week progresses.

Market Implications

For participants, initially at least, focus is almost solely on capital preservation, as havens are sought, books squared up, and the hatches battened down amid incredibly choppy and volatile conditions. While those conditions remain orderly, and predictable, heightened volatility nonetheless necessitates a change to strategy, namely smaller position sizing, and wider stops.

As time goes on, however, and the initial ‘shock factor’ of the weekend’s strikes continues to fade, the ‘half-life’ of geopolitical headlines is likely to continue to shrink, providing that the situation doesn’t materially escalate. So long as this remains the case, it seems plausible that this will be another geopolitical episode that causes a short-term market reaction, and not a long-lasting or durable change in the overall broader narrative, which remains one of a robust global economy, and a positive risk-taking backdrop.