Latest threat to stock-market rally? Investors suddenly fear geopolitical risks.

By José Adinolfi

Concerns about possible Iranian retaliation against Israel added to weekly decline in stocks

Investors seemed perfectly content to ignore geopolitical risks for most of last year.

But that appears to have changed as of Thursday afternoon in New York, according to analysts at Bespoke Investment Group, who pointed to speculation that Israel could be preparing for a military attack from Iran as a catalyst for a violent stock reversal.

Israel had demolished an Iranian consulate in Syria earlier in the week, contributing to higher crude oil prices.

Some market analysts now warn that the powder keg in the Middle East could ultimately do more damage to stocks than a delay in the start of the Federal Reserve's interest rate cuts, potentially becoming a rare example in which Geopolitical risks have a lasting impact on markets.

"Stock investors are not particularly good at assessing geopolitical risk and how it could affect markets," Steve Sosnick, chief market strategist at Interactive Brokers, said during an interview with MarketWatch. "It's one of those things that tends to be in the background until it suddenly isn't, and then sometimes we have an overreaction when they start paying attention."

While U.S. stock indicators ended higher on Friday, they fell Thursday afternoon, with the Dow Jones Industrial Average DJIA shedding a sizable gain to finish 530 points lower, its biggest daily drop in more than a year, according to Dow Jones. Market Data.

Treasury yields rose on Friday but fell on Thursday, despite comments from Minneapolis Federal Reserve Bank President Neel Kashkari, who raised the possibility of the Fed leaving interest rates unchanged. changes until next year. For the Bespoke team, the weak reaction in bond yields was a sign that fears about an Iranian escalation, and not the changing outlook for interest rates, were the main culprit behind the stock sell-off.

In light of this, it is worth examining why stocks suddenly appear to be reacting to tensions between Iran and Israel six months after the start of the war between Israel and Hamas. Stocks initially shrugged off the Oct. 7 Hamas attack, and the S&P 500 SPX ended higher on Oct. 9, according to FactSet data.

One reason investors tend not to react to geopolitics is that they rarely have a lasting impact on corporate profits, according to Savita Subramanian, head of US Quantitative and Equity Strategy at BofA Global Research. who analyzed the issue in a report published shortly after the Hamas attack. Israel on October 7. Unless geopolitical shocks affect the underlying economy, the resulting market sell-off tends to be short-lived, presenting an opportunity for investors to buy the dip after a sell-off of between 5% and 10%, she said.

Major geopolitical events of the past three decades, including the 9/11 terrorist attacks and the United Kingdom's vote to leave the European Union, had only a fleeting impact on markets, Subramanian noted.

Even the impact of Russia's war with Ukraine faded as crude oil prices retreated from their peak of around $130 a barrel. The Federal Reserve has identified supply chain problems caused by the COVID-19 pandemic as the main driver of the inflation wave that shook markets in 2022, while the Biden administration initially blamed Russia.

However, any broader conflict in the Middle East involving Israel and Iran could produce a level of economic setback that could force investors to react.

A rise in crude oil prices, given the large production operations in the Middle East, could be an obvious problem. While abundant supplies of U.S. crude should soften the impact on U.S. consumers, Subramanian noted that U.S. multinationals' corporate profits could be hit by further disruptions to global trade, falling demand for foreign travel and a consumer weaker European if another energy shock emerges, pushing Europe into a recession.

All of these factors could depress global stocks for more than a few months, Subramanian said.

There are certainly areas of the market that could benefit, such as the aerospace and defense industry. The SPDR S&P Aerospace & Defense ETF XAR is off to a muted start to 2024, up just 1.7% year to date on Friday. Energy companies could also benefit from rising crude oil prices.

Ed Yardeni, president and chief market strategist at Yardeni Research, has long warned that investors should not downplay conflict risks in the Middle East. He has identified the potential for a regional war as a major risk to his generally bullish outlook on markets.

Yardeni returned with a new warning on Friday, saying that if tensions between Israel and Iran escalate into a broader conflict, the 2020s could ultimately resemble the 1970s, a notoriously poor decade for equity market performance. values, in a note to a client.

"Historically, over the years, geopolitical crises have been opportunities to buy. But this crisis in the Middle East is not going away, it is getting worse," Yardeni said in an interview with CNBC on Thursday night.

U.S. stocks closed higher on Friday, with the S&P 500 rising 57 points, or 1.1%, ending at 5,204, while the Dow Jones Industrial Average gained 0.8% and the tech-heavy Nasdaq Composite COMP. rose 1.2%.

Still, all three indices finished the week lower, with the Dow Jones posting its worst week in a year. Rising crude oil prices and higher Treasury yields over the past week were also blamed for the recent pullback in stocks.

Yardeni sees the risk of broader conflict in the Middle East as an even bigger threat to markets than the Federal Reserve's decision to keep interest rates unchanged for the rest of 2024.

"Geopolitics is my number one concern. I won't worry if the Fed doesn't lower interest rates because that will be consistent with my view that the economy is resilient," he told CNBC.

-Jose Adinolfi

This content was created by MarketWatch, operated by Dow Jones & Co. MarketWatch is published independently of Dow Jones Newswires and The Wall Street Journal.


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04-06-24 0800ET

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