Middle East conflict: Is the markets’ restrained reaction appropriate?

The hostilities between Israel and Iran have been ongoing since last Friday. According to the markets’ reaction so far, they expect the conflict to remain limited. For example, the oil price has risen only slightly: from Thursday to Monday from 69 to 79 US dollars per barrel. The question is whether the market development is too indifferent or proportionate to the risks. Indeed, in recent decades, rising geopolitical risk premiums (i.e. lower equity prices, higher bond prices and higher yield spreads) have not stayed in the market for long. Will it be different this time?

Negotiations so far unsuccessful

It is Israel’s declared goal to eliminate the existential threat posed by Iran’s nuclear programme. In principle, there are three ways to achieve this:

• Negotiations with the existing government
• a military intervention
• a change of regime and subsequent negotiations.

Israel has obviously come to the conclusion that option one is no longer viable. There were increasing indications that Iran was close to producing weapons-grade material. There may also be other reasons (domestic politics, weakening of Iranian militias around Israel).

Military solution

During the night of 12 to 13 June, Israel began bombing nuclear facilities, missile launch bases and military installations, and killing high-ranking military personnel and scientists. The action suggests a well-thought-out plan. After all, Israel seems to have almost achieved air superiority. Iran has responded with missile and drone strikes on Israel. How long can this go on?

According to analysts, Israel cannot defeat Iran. Even the complete destruction of the nuclear programme is considered unlikely. The aim is therefore to weaken Iran’s ability to build and launch nuclear bombs in the near future. Analysts say that it could take at least two weeks before any weakening of Iran’s nuclear programme becomes apparent. According to reports, around a third of the nuclear programme has been hit so far. However, those facilities buried deep underground, such as in Fordo, pose a challenge. It is unclear whether a heavy bomb such as the US military’s Massive Ordnance Penetrator (MOP) is sufficient for this. How long the mutual bombardment will continue also depends on ammunition stocks. Israel is trying to take out Iran’s missile launchers before its stockpiles of interceptors are depleted.

Failure

What will happen if the strike fails, i.e. if Iran’s nuclear programme is not sufficiently weakened? A return to the negotiating table is possible, but seems unrealistic given Israel’s motivation for the attack. Moreover, Iran’s leadership needs the nuclear programme as a (life) insurance policy. Iran will now probably be even more motivated to push ahead with its nuclear programme as quickly as possible.

Regime change

That is why option three, regime change, is also being pursued. Israeli Prime Minister Benjamin Netanyahu said that his armed forces would ‘do what we have to do’ against the Iranian leadership. Regime change could ‘certainly be the result’ of Israeli attacks on the Islamic Republic. If such a change were to succeed, there is a risk of state collapse (failed state, fragmentation into individual factions, ungovernability). Such a development could destabilise the entire region. A better outcome would probably be a military government willing to enter into credible negotiations with Israel on ending Iran’s nuclear programme. A liberal, pro-Western form of government is rather unrealistic.

Oil infrastructure

Because the conflict revolves largely around the direct or indirect removal of the current regime in Iran, there is an increased risk of escalation affecting oil infrastructure in the Middle East. Iran could attack oil production facilities in neighbouring Arab countries or attempt to close the Strait of Hormuz. Around 17 million barrels of oil are transported through the strait every day, which corresponds to around 20 to 30 percent of global oil consumption. The strait is the most important shipping route for oil exports and is considered a major bottleneck for oil transit.

US involvement

The US emphasises that it is not involved in the attack on Iran. Should the superpower USA ultimately be drawn into the hostilities (protection of oil production facilities, attack on nuclear facilities), the conflict will reach a new level. This primarily concerns the famous unintended consequences (global terrorist attacks, new alliances, Iran becoming a failed state, etc.).

The Iran risk has added a new factor of uncertainty to the markets. As if the unorthodox US policy were not enough. The calm market reaction to the attack on Iran seems justified as long as the conflict between Israel and Iran remains contained. However, if the situation escalates (destruction of oil production facilities outside Iran, closure of the Strait of Hormuz, involvement of the US), oil prices could rise sharply. In this case, the probability of a recession would increase (negative for equities, positive for bonds). Only if the rise in oil prices were to become permanent (as in the 1970s) would concerns about prolonged stagflation emerge (negative for equities and bonds at the same time). For the time being, however, the market remains calm.

 

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