- Market implications are perhaps to the most linear.
- Higher oil price and safe haven flows to USD and gold are on the cards.
- But the conflict’s fallout goes well beyond the short term.
- A protracted conflict will be damaging to a large part of the Middle East.
- Civil conflict within Iran has multiple international dimensions; spillover risks are substantial.
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Ongoing attacks by Israel and the US on Iran are at once expected and yet astonishing. The scale of the attack and retaliation, the damage already inflicted, the heightened uncertainty about what comes next, are extensive in scope.
All this makes for a particularly testing time for risk managers and market participants. We have the following considerations:
First, Iran is not remotely capable of matching the firepower of Israel and the US, but its ability to engage in asymmetric warfare is substantial. Unlike say Venezuela, where President Maduro had a weak chain of command, Iran is structured in a more decentralized manner. The clergy, the military, the Revolutionary Guard, and the intelligence service form multiple centres of power, all of which can survive attacks on their leadership. Beyond command and control, there is the issue of military hardware. Presently, Iran is launching drones and missiles, but their effectiveness is limited and the supplies are constrained. However, even after drone and ballistic missile stocks run out, low intensity but highly disruptive attacks can continue inside and outside of Iran.
Take the issue of the Straits of Hormuz, bordering Iran to the east, through which 20% of the world’s oil and LNG supplies flow. The Iranian Navy’s warships may not be able to do much there, as they are in the process of being decimated by US air attack. But the ability to drop mines along the waters of the Straits, using small subs or fast boats, is considerable, and very difficult to neutralise. If the US has to help oil and LNG tankers navigate through the mines, the pace of shipment would slow significantly. The implication for energy price, shipment cost, and insurance charge is obvious.
Second, there are the regional geopolitical dimensions. Many Iranians oppose the present government; those opposing the regime have been receiving substantial support from Israel, US, and the diaspora. The movement will surely gather strength in the coming days as attacks on the regime continue. But at the same time, there will be fears of what comes next. The regime, in power for 37 years, is entrenched in the society, with the ability to create major friction even when out of power. This risk could be compared with the Iraqi civil war after the demise of the Saddam Hossain-led Ba’athist regime in 2003. We are worried that the risk could well be more as there doesn’t appear to be any appetite for ground level involvement by the US, as was the case in Iraq. With Kurds in the north and Baluchis in the south, regime change may coincide with wars of cessation, dragging in several countries in the region, from Turkey to Iraq.
Beyond energy and shipping costs, here are some financial market implications:
- Safe haven currencies to rally, from the USD to JPY.
- Equity market sentiments, already fragile lately, would exacerbate.
- Gold to rally.
- Spreads, sovereign and corporate, to widen.
Monetary policy to stay put in the near term, unless market selloff is severe. If energy prices remain elevated for months, then the narrative for further accommodation would be challenged.
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