Middle East risk levels revisited

Introduction and background
For many years an uneasy but relatively stable political equilibrium existed in the Middle East that allowed Israel to normalise diplomatic relations with several of its Arab neighbours, encouraged by the US. The situation was not perfect, but a version of normality had emerged that brought with it greater economic stability and prosperity for many countries in the region. Chart 1 shows how geopolitical risk in Israel had declined steadily in the two decades starting from 2002.

That all changed following the Hamas attack on 7 October 2023, provoking a powerful response from Israel. We are now one year on from that attack and sadly there is no resolution in sight. Gaza is reduced to rubble, there is a growing humanitarian crisis and Hamas still has around 100 Israeli hostages.

Chart 1. Israel: Geopolitical Risk Index (12 month moving-average)

Source: Data downloaded from https://www.matteoiacoviello.com/gpr.htm on 9-Oct-2024

Recent developments
Until recently the unfolding tragedy had been largely contained to Israel and Gaza. It is true that people had been forced to vacate their homes in northern Israel and there had been a growing number of incidents in the West Bank, but other players and organisations in the region seemed largely content either to say little or to offer words of support backed with only limited actions. However, the past few weeks have seen an undoubted escalation that began with exploding pagers and walkie-talkies and that has developed into Israeli bombing of Hezbollah targets across Lebanon, including in the capital Beirut. Furthermore, for the second time this year Iran launched a direct missile attack against Israel.

The first Iranian missile attack in April was carefully managed in such a way that it achieved multiple objectives:

• It sent a message to Israel that there would be no free ride;
• It allowed the Iranian authorities to appease their domestic audience; BUT
• It was sufficiently well signalled and calibrated to allow Israel and its allies to thwart the attack, thereby minimising the likelihood of escalation.

The latest attack was not dissimilar in that it appeared to be more about sending a message to Israel than wishing to enter a full-blown war. Nonetheless, it is clear that the unwritten rules of engagement between the two countries have subtly but importantly changed. 

Whereas conflict between Israel and Iran used to be covert, there are now open military exchanges. While there was plenty of warning ahead of the April attack, there was a much shorter window ahead of the most recent missile barrage. And the rhetoric on both sides has become more openly provocative and accusatory. The risk therefore remains that each subsequent military engagement represents a small incremental step towards full blown war. As this happens, actions that previously would have been considered out-of-scope will increasingly enter the sphere of acceptability on both sides.

This is important in the context of recent developments. The debate in Iran no longer needs to focus on whether it would be appropriate to launch a missile attack, but rather on the nature of that attack. Furthermore, it has become increasingly difficult for Iran to stand by and watch without doing anything, as that might risk its proxies becoming less loyal, thereby reducing trust in their paymasters.

Four levels of risk
While these developments are very worrying, so far financial markets have largely shrugged them off. For some people, that is perhaps surprising. In terms of understanding why this is and having a framework around which to analyse possible future developments, it is instructive to think about four levels of risk, as highlighted in a report published last year and shown again in Chart 2 below.¹

Chart 2. Risk levels

Source: EFG. This is for illustrative purposes only

This represents an over-simplification but is nonetheless useful as an analytical tool. The first two risk levels – Local Contained and Regional Contained – are of limited importance for markets. Whilst such events are very painful for the affected people, there is only a small impact on the global economy since they often take place in parts of the world that are not well-connected to the international system. 

We were for a long time in the first risk level but have more recently moved into the second risk level. This represents a broader regional conflict but the impact on the global economy and markets remains contained. What is more concerning is the possibility that the situation escalates further into the third level of risk in which the energy sector is affected. This could come about in several ways. For example, if Israel were to attack Iranian oil infrastructure resulting in reduced global oil supply or if Iran were to lay mines in the Strait of Hormuz, through which around 20% of the world’s oil supply is transported.² As a corollary to this, it may well be that the Iranian-backed Houthi rebels in Yemen ramp up their attacks on shipping in the Red Sea, something that is separate to the oil effect but that would have similar repercussions in terms of adding to inflationary pressures.

Chart 3. Oil transported through the Strait of Hormuz

Source: US Energy Information Administration. Data as at end 2023

The fourth level of risk would entail a situation in which there is broader global conflict. This would occur if the US and associated allies of Israel were to ramp up their military involvement. That might then encourage other anti-US nations to respond more forcefully, either directly or via proxies, with unknown consequences.

Market discussion
Note that it is not the direct impact of events in the Middle East that matters for markets but rather the possibility that the situation has a meaningful influence on factors such as global growth, inflationary dynamics and the corporate outlook. In this context the first two risk levels may be associated with some short-term volatility but rarely anything more. Markets are discounting mechanisms that quickly assess, absorb and price the relevant information, hence the muted market response.

We had a taste of the potential impact of third level escalation when Russia invaded Ukraine in 2022 and the price of oil and other commodities increased dramatically, feeding through in turn to higher inflation, rising interest rates and volatile equity markets. It is notable, however, that since then OPEC+ members have imposed oil output caps, suggesting that if there were unwelcome stress in global energy markets it would be possible for some OPEC+ members to increase oil output as an offset.

To illustrate this, note that Saudi Arabia is currently producing around 9 million barrels per day (mbpd) relative to a peak of about 11 mbpd in 2022. Iran currently produces about 4 mbpd relative to approximately 2.6 mbpd during the period between 2018 and 2021 when sanctions were imposed. The 2 mbpd of spare Saudi Capacity would therefore be more than sufficient to plug the gap should Iranian oil production drop by an amount similar to the most recently imposed sanction period (1.4 mbpd).³

Furthermore, there is the possibility that US shale oil producers increase production in response to the prospect of higher prices. It therefore seems reasonable to assume that there would be a counterbalance in terms of oil supply dynamics should Iranian oil supply falter.

Summary
In summary, it can be hard to reconcile rapidly rising tensions in the Middle East with benign markets. This apparent contradiction can be explained by the expected muted impact on factors that matter for markets such as growth, inflation and corporate profitability. That calmness would likely change if the situation were to escalate further, for example if energy markets experienced a supply shock that resulted in a sharp increase in oil prices. That is a classic mechanism via which geopolitical events transmit to financial markets.

If that were to happen, one would expect to see forecasts of inflation and interest rates shift higher, which could bring about a sell-off in bonds, an increase in equity market volatility and reduced growth forecasts, notably for oil importing countries. The level of escalation after that would entail much greater global involvement. In turn, one would expect that to be associated with a worsening outlook for risk assets. The table from the report released last year remains relevant and is repeated in the Appendix for reference.

Whilst tail risk events are, by definition, low probability, the potential impact can be very large. Even though the core expectation is that the situation in the Middle East will remain contained, the escalation risks have clearly risen recently and so it makes sense to position portfolios accordingly, with some exposure to assets that would be expected to rally should the situation suddenly worsen dramatically.

Appendix. Market impact of escalating risk

Source: EFG. As at 09 October 2024

¹ ʺGeopolitical Updateʺ Macro Flash Note, 15 November 2023.
² https://www.eia.gov/international/analysis/special-topics/World_Oil_Transit_Chokepoints.
³ The ability of Saudi Arabia to fill the void if Iranian production were to plummet is contingent on the Strait of Hormuz remaining operational.