In the early morning hours of Saturday, 7 October 2023, Hamas launched a large-scale terrorist attack on Israel. The humanitarian costs of these tragic events transcend any financial market considerations. Below, we endeavor to provide as objective an interim assessment and evaluation of the impact on financial markets as possible.
A war in Gaza last began on 8 July 2014, in response to sustained rocket fire at Israel by Hamas and other Palestinian militant groups from Gaza. At that time, the conflict ended some seven weeks later on 26 August 2014, with an indefinite ceasefire. At the time, reactions on the financial markets remained muted. Neither the oil price nor gold saw significant swings, while the world stock index slumped by around 4% at times, although it recovered this by 26 August 2014. The reaction on financial markets was stronger this time: Both the oil price and gold gained around 8% in the first two weeks after the outbreak of the conflict. While in 2014 United States shale oil production was running at full speed, today global oil supply appears tighter given existing OPEC+ supply cuts and record low inventories. And even though China's growth is weakening, oil imports increased by an estimated 12% over the past twelve months.
The surprise effect of the current conflict has been enormous. Nevertheless, it should not be viewed in isolation. The conflict escalated in the overall context of rising interest rates, tight monetary conditions, a fragile macro environment, and an America that is only capable of limited political action. The US Volatility Index VIX has skyrocketed by about 26% since the conflict erupted. However, the world equity index fell by only 2% over this period, but by a total of more than 3% last month. Here, the rise in ten-year US Treasury bond yields from 4.4% to nearly 5.0% played a major role, as higher rates pushed the equity risk premium further down and weighed on valuation multiples. This has certainly contributed to the S&P 500's recent downward breach of its 200-day moving average. On the other hand, the important support line of 4,200 points has held so far.
The current situation remains tense. Investors are particularly worried about a possible interference of Hezbollah, the Hamas-allied "Party of God" in Lebanon, one of the most powerful paramilitary forces in the Middle East, whose military strength is estimated at around ten times that of Hamas. This could expand the conflict into Lebanon and possibly lead to Iranian interference. Thus, the conflict would destabilize the Middle East, which is important for oil production, and possibly affect the Strait of Hormuz, through which an estimated 25% of the global supply of oil passes. Thus, risks to higher oil prices remain for now.
Israel's primary objective is to eradicate Hamas's military capabilities. A targeted military operation, localized to Gaza, of limited duration and hopefully limited casualties, after which Palestinian authorities replace Hamas as the ruling party in Gaza, remains a possible scenario. In addition, there are massive diplomatic efforts by the US government to contain the conflict in the Middle East. Currently, many estimates are circulating in the market. A majority of political analysts seem to estimate the probability of the current conflict remaining locally contained at around 70%, with a 30% risk of further escalation.
Recent investor surveys show extremely pessimistic investor sentiment after the S&P 500 has declined in five of the past seven weeks. In addition, global investors are again holding above-average amounts of liquidity, also a sign of risk aversion. The ratio of put-to-call options in the US is currently higher than at the time of the corona pandemic outbreak, a sign of enormous demand for hedging instruments. When such a clear majority of investors think in the same direction, this can also be interpreted as a contra-indicator from which a countermovement can result. The fundamental explanation for this is that if many think in one direction, a correspondingly large number can change their minds, and a broader shift in mindset on capital market flows can be correspondingly price-driving. Historically, monetary tightening often ends during war times. It can therefore not be ruled out that US interest rates are now trading near the peak for this cycle, which would at least suggest no additional pressure for even higher rates ahead.
The current situation with this complex puzzle pieces such as the war in the Middle East and the ongoing conflict in Ukraine, significantly increased interest rates, tense monetary conditions, a fragile macro environment and a politically only partially capable America create a high level of complexity, with correspondingly high risks. This is not an environment for big "bets" in our view. We remain positioned close to our robust, strategic asset allocation, in which we have high confidence in times of crisis. Despite the continuing high level of complexity, an assessment by investors should always be as "rounded" as possible. The currently significantly increased risks are offset by an extremely pessimistic investor sentiment, which can also lead to counter movements at any time.