Investors focus on the Middle East - the week ahead

Just one story is dominating the headlines this week. Investors are weighing up different scenarios after the US bombed Iran at the weekend.

What next?

Investment markets move quickly from what has happened to what comes next. This weekend’s escalation of tensions in the Middle East has been no exception to this rule.

Unsurprisingly, the oil price has borne the brunt of investors’ initial scenario analysis following the quicker-than-expected intervention by the US in the ongoing hostilities between Israel and Iran.

The price of a barrel of Brent crude, already up more than 10% from its lows, added another 6% after Sunday’s attacks on three Iranian nuclear facilities before paring the gain to less than 1%. It currently stands at around $77 a barrel.

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Stock markets were even more circumspect. The MSCI Asia Pacific index fell less than 1% as investors had their first chance to react. Then markets in Europe, including the FTSE 100, fell by less than 0.5%. US futures, at the time of writing, were broadly unchanged.

Meanwhile, traditional safe haven assets - US Treasuries and the dollar - were modestly stronger or unchanged. The dollar rose slightly against a basket of other currencies. The yield on US 10-year bonds held at roughly 4.4%.

Investors are weighing up likely responses from Iran. There are three main possibilities. First, a weakened Iran backs down and agrees a negotiated settlement with Israel and the US. That would probably lead to a relief rally.

Second, Iran avoids direct conflict but attempts instead to disrupt the flow of oil through the Strait of Hormuz, a key choke point for seaborne oil exports from the Gulf. This would probably lead to a spike in the oil price, although the oil market remains well-supplied and demand from leading economies (US and China) is subdued. It is thought only a rise above $100 a barrel would have a serious impact on economic growth and that remains a low probability.

Third, Iran retaliates with attacks on US assets in the region, dragging America into a potentially prolonged conflict. This is clearly the worst-case scenario and would have an impact on the risk premium attached to global investments. Even with this outcome, however, history suggests a possibly limited impact on markets. Shares rose after the US’s attack on Afghanistan in 2001 and again after the invasion of Iraq in 2003.

The unsentimental reality is that the global economy is much less energy intensive than it was in the 1970s when conflict in the Middle East had a dramatic stag-flationary impact on western economies.

Resilient markets

Another explanation for markets’ calmness in the face of a dramatic ratcheting up of global tensions is that it comes at a time of diminished concerns about the impact of tariffs on growth and inflation. Although a 90-day pause on the implementation of tariffs is due to expire in July, most analysts feel that the US has stepped back from its initial hardline approach on trade. The prevailing narrative is that tariffs are a negotiating ploy and that trading agreements such as the one put in place between the US and UK recently will reduce the likelihood of a damaging trade war.

The way in which markets have held onto the dramatic recovery from the ‘Liberation day’ tariffs-fuelled correction between February and April is still somewhat surprising. US markets are back within a couple of percentage points of February’s all-time high. And this comes in the face of an ongoing rotation out of US assets as investors question the sustainability of US debts and deficits and worry about the unpredictability of US trade and economic policy.

Fiscal dominance

The growing importance of US debts and deficits is, in fact, an emerging market story. Some analysts believe it heralds an era of so-called fiscal dominance - a situation in which central banks have a reduced ability to manage the ups and downs of the economy through monetary policy.

High debts mean central banks can find themselves unable to maintain interest rates at a level that keeps inflation in check due to the risk that tight monetary policy triggers a sovereign debt crisis on the back of excessive government borrowing costs. Even if central banks do keep interest rates high, the bonds governments are obliged to issue, just to finance their borrowings, adds to the money supply and so fuels further inflation.

Long after the Middle East falls out of the headlines again, this battle between fiscal and monetary dominance threatens to hang over financial markets. It is a topic that on which investors will be increasingly focused.

Read:

• Europe’s stock markets are finally having their moment in the sun
• What is the best way to invest in gold - ETFs or gold miners?
• What can we expect in the Autumn Budget?

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.