Client Update - 12th October 2023

In this earlier than normal weekly update, it is only right that I cover initial implications of the situation unfolding in Israel. The important disclaimer here is that markets are of trivial importance compared with the value of human life. Financial commentary is therefore an aside to the story in Israel and Gaza. Having said this, you are clients of our firm, and the value of your portfolios have the potential to be impacted by these events, so I will go on.

The global geopolitical risk environment changed over last weekend in a significant way. At moments like this, there is a temptation to think that the great collective weighing machines known as the equity and bond markets might offer important insights into what is going on and what might happen next. “What is the market telling us?” becomes a common question. This temptation ought to be resisted. I have never seen evidence that markets are particularly good at gauging geopolitical risk (which is why the market rewards for good geopolitical judgment can be so high).

I do not think there is much to learn from the market about the implications of the developing conflict. Monday’s action in the oil market, the one most directly implicated in the conflict, is a good example. Brent crude rose by almost $4 a barrel, or 4.5 per cent to $88. Not only is that only a normal daily uptrend in oil prices, it looks smaller still in the context of the $11 drop in prices of last week. In the absence of a war, the day’s move might have looked like a normal rebound. Does the muted move make sense? Does the war create only a smallish risk of higher oil prices, on balance?

That doesn’t seem quite right. Two main risks have the attention of oil watchers right now. The larger of the two is that Iran could be implicated in the planning or execution of the attack on Israel, leading to tighter international enforcement of sanctions and reducing Iranian oil exports.

The second risk is that tensions in the region push Saudi Arabia to sustain its current production limits. It had been reported that the Saudis would be willing to increase output to help secure normalised relations with Israel. The prospect of normalisation seems a lot dimmer than it did a week ago but, again, the odds and the timing are up in the air. Admittedly neither of these two risks seem likely, in themselves, to create a price shock (and ensuing inflationary crisis).

Still, there are less probable but more severe tail risks that have to be considered as well. An outright military conflict involving Iran could lead to much larger disruptions, including but not limited to the closure of the Strait of Hormuz. Are there extreme, unlikely, but non-trivial scenarios priced in? How would one know if they were? Very significant new risks were, without question, introduced to the oil market over the weekend. But these risks are highly complex and hard to define. So the market, not knowing what to do, did essentially nothing.

Looking at the oil market tells you very little about how the geopolitical risk environment just changed. What seems likely is that the oil market is in the dark with the rest of us, and therefore initially responded with a small risk-off twitch, and then carried on as before. Energy and defence stocks have risen, but mostly global equity markets responded with a shrug and then with a bounce when US Federal Reserve officials spoke on Monday that rates may not stay high for that long after all – evidently in response to the crisis developing over the weekend.

The market does not understand wars any better than the rest of us do. We have our eye on this developing conflict, and we will adapt our portfolios as and when required. For now, we will continue to think about those impacted in the region by these tragic events and hope that this conflict can be resolved as soon as possible. As always, if you have any questions, please do be in touch.