How to Prepare for Whatever Comes Next in the Middle East
Here are the likely outcomes for the market whether Israel-Iran tensions escalate or deescalate this weekend.
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Following a military strike in Iran by Israel and escalating geopolitical tensions, let’s look at how to position for some potential outcomes.
Escalation
As this escalates, look for energy prices to rise rapidly. This needs to be contained for energy market reactions to remain “muted.” The ability to ship is the first order issue. If it becomes unsafe to transport fuel, that would have major consequences. Individual production facilities getting hit would also have ramifications for higher oil prices.
The ability of Saudi Arabia to pump and ship is key.
Could the Trump administration back off of tariffs, say on Canadian energy, to mitigate the price rise? China is most directly affected (as it gets supplies from Iran), but oil is fungible, so it could bid up prices in search of necessary supply.
My understanding is that diesel is most at risk. I'm looking into this more, but that could affect industry and agriculture (which are more dependent on diesel than gasoline).
Treasuries will start to act like a “safe haven.” Globally, rates went higher, partly due to the inflation risk of higher oil, but the risk of increased military spending, likely also played a role. The Fed and central banks across the globe will not be afraid to cut because oil went higher on the back of military action in the Middle East. They will likely view that as transitory, and be largely accurate this time on the use of the word.
While we all may view increased prices at the pump as inflationary, it will not weigh on the Fed thought process much (it is why we have CPI excluding food and energy). The weakening made some sense if there wasn’t a strong response (even then it seemed overdone), but that should reverse with true escalation (yes, deficit spending will increase, but central banks will become worried about the global economy).
Deescalation
We could wake up on Monday morning and things across the globe could be smoother. Iran decides it has had enough and negotiates more earnestly for a nuclear deal that Israel can accept. Heck, we could see an uprising in Iran (seems like wishful thinking, but...). In these cases we’d wake up to a massive rally in risk assets, but I’d prepare for escalation.
Negotiations across the globe? We don’t have a Russia/Ukraine deal. At this moment in time, we are far from a deal with Iran. The U.S. has one, somewhat detailed, trade agreement with the U.K. and something with China (it would be awesome to see the administration fixate on building out the U.S. capacity to process and refine rare earths and critical minerals — they can work on sourcing them directly, but the key is processing/refining).
China’s chokehold on processed and refined rare earths and critical minerals is almost unbelievable. Maybe the recent tariff negotiations will have highlighted that and lit a fire under the administration to pursue that as rapidly and aggressively as possible (even using subsidies if necessary)? In any case, as ongoing trade deals are being negotiated, the U.S. will have fewer resources to focus on them, and it is difficult to see other countries viewing the U.S. as strong as they might have feared when talks began.
If that is a correct interpretation, expect more extensions and pauses (kind of the consensus view anyways), but also look at tariffs to once again weigh on markets. Nothing like when the Liberation Day tariffs looked like the status quo, but markets have come a long way, and may be pricing in too much optimism (especially if we are correct in our assessment that the NFP Establishment Headline number, is already overstating the actual job situation).
Risk off seems to be the best positioning, while owning a dose of energy, as so many are underweight that sector, we could see a nice pop, even with some resolution. The longer this doesn’t defuse itself, the more the potential for a squeeze/catch up to market weight, to kick in and move energy stocks higher. I own and added recently to XOP and XLE.
At the time of publication, Tchir was long XOP and XLE.
