The Market Implications of Middle East Turmoil

The Market Implications of Middle East Turmoil




The conflict in Syria is very complex, given the country’s diverse ethnic mix and the influence of foreign powers. This implies a high risk of a further dramatic escalation of the conflict, with negative spillovers into the broader region. Short term, UBS notes that the response of the Assad regime to a potential military strike will be crucial, while a key question for the medium term will be whether state structures can be preserved in Syria, so that contagious chaos can be avoided. UBS sees the impact on the international economy comes mainly via risk appetite and oil prices. Should the conflict be contained, the global economic fallout should be limited. However, the worst-case scenario of a regional spread of hostilities, involving Iran, Israel or the GCC, would be a lot more damaging.

Via UBS' Stephane Deo,

Market implications
There are essentially two channels by which the situation can impact markets: an increase in oil prices and a decline in risk appetite. We show that such a supply shock on oil prices would have a straightforward negative effect on risky assets, notably equities. The impact on yields is less obvious as inflation expectations would surge. On balance though, we think higher oil prices would create a FI rally only if they derail the nascent recovery. We also analyse market reactions in case of a surge in risk aversion. We find that the only place to “hide” is the US yield curve. We also provide historical analysis of the optimal portfolios for different risk regimes.

Oil prices

We do not think that Syria per se is large enough to have a meaningful and long-lasting impact on oil prices. However, more widespread turmoil in the region, or simply markets pricing in a greater geopolitical risk premium, could definitely have an impact on oil pricing. The correlation between oil price and the stock market can change as the two charts below demonstrate. The reason is simple: a supply shock will generate a negative correlation between oil and the stock market. The example we chose is the 1990-1991 period during the first Gulf War.

 

Chart 2 clearly shows that oil prices were driving the S&P down. Conversely, if oil prices move because of greater demand, the correlation with the S&P is positive. In our example (Chart 3), the phase of strong growth at the end of the 1990s was associated with rising stock market and oil prices and indeed both oil prices and the stock market fell at the end of 2001 when growth faltered.

 

So the implication of a surge in oil prices on risky assets would be straightforward: the impact on growth as well as the impact on risk appetite would push risky asset prices down.

The correlation with safe havens, especially risk-free rates, is much more difficult to analyse. Indeed, the economic slowdown from a surge in oil prices should reduce yields, but the surge in inflation should increase yields. The easy part of the curve to forecast is thus break-even inflation (BEI), and indeed the short part of the BEI curve is highly correlated with energy prices, which contribute to a large share of the short-term volatility in actual inflation.

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