Middle East tensions

Geopolitical events are, by their nature, unpredictable and highly idiosyncratic. As such, the market response tends to vary enormously from one event to the next. Even though there have been multiple military flare-ups in the Middle East over the years, each one has unique features, with some lasting for a few days, some a few months and others taking several years to resolve. Furthermore, it is very difficult to draw strong consistent messages about the likely influence on financial markets. This is true for geopolitical events as a whole: because of the individuality of each event the consequences are very hard to predict. Many such events affect parts of the world that do not have well-developed financial markets, that do not have large economies and that are not well-connected to global trade. The market and macro impact is therefore often relatively small.

Chart 1 shows prior periods when geopolitical risk (GPR) was elevated and Table 1 shows the performance of various financial indices during these periods.

Chart 1. Periods of geopolitical stress

Source: Caldara, Dario and Matteo Iacoviello (2022), “Measuring Geopolitical Risk,” American Economic Review, April, 112(4), pp.1194-1225, Bloomberg, EFG calculations. Data as at 11 October 2023.

Table 1. Financial market performance during prior periods of heightened geopolitical stress

WTI = West Texas Intermediate, GSCI = Goldman Sachs Commodity Index, DXY = trade weighted US dollar, VIX = Chicago Board Options Exchange Volatility Index, T10 = 10-year Treasury yield.

Source: Caldara, Dario and Matteo Iacoviello (2022), “Measuring Geopolitical Risk,” American Economic Review, April, 112(4), pp.1194-1225, Bloomberg, EFG calculations. Data as at 11 October 2023.

The chart and table illustrate two main points:

1. Often there is a spike in geopolitical risk that quickly subsides;
2. Financial markets do not respond in consistent, predictable ways.

For most of the indices shown in the table, approximately half of the time there was a rally during periods of heightened geopolitical risk and approximately half of the time the index sold off. The asset for which there is the most consistent response is the 10-year Treasury yield, which declined in seven of the 10 episodes identified. However, the scale of the decline in yields was relatively modest. Moreover, yields were in a structural downtrend for most of the past 40 years so it is not clear that the yield declines experienced during the identified periods were any greater than would have been expected as part of the trend.

The table also challenges some popularly held beliefs about market behaviour during periods of increased risk. For example, while gold rallied in six out of 10 occasions, it sold off in the other four. Similarly, the VIX index of implied volatility has sometimes increased and sometimes decreased when geopolitical risks have risen.

In terms of the current situation, there has not been much of an influence on markets so far and that seems to be a rational response to what is likely to remain a localised incident. There is undoubtedly a risk of escalation and a wider impact and that risk grows the longer the situation persists. The most likely channel in which this will be expressed is via energy markets. For example, about 10% of global oil supply relies on transport through the Straits of Hormuz. Perhaps ironically, higher energy prices would be of benefit to the government finances of many countries in the region although would also reignite fears of inflation and slower growth in much of the developed world; occasionally there is a more profound market reaction to geopolitical events, as we saw with events in Ukraine last year. The human cost of the conflict is both sad and terrible but, at the moment, the financial and economic spill-over effects seem well contained.