October 24, 2023
In the words of former U.S. General David Petraeus, “The region is holding its collective breath”. The horrific civilian casualties of October 7th are too much to bear and will long be remembered alongside 9/11 as one of the worst terror attacks in the last 25 years. Now with Israel preparing to descend into Gaza by air, sea and land to eliminate Hamas from their southern border, the toll of human suffering and urgent humanitarian crisis will continue as the ground war likely will not resolve itself anytime soon.
As investors, we understand geopolitical risk is an ever-present reality. When events occur, we need to be as disciplined as possible about evaluating potential impacts on the global economy and financial markets – which is our primary focus here.
In terms of consequential economic impacts, we know conflicts in the Middle East can ripple through the global economy as the region is a key producer of energy supplies. The region currently houses roughly half of the world’s proven oil reserves and roughly 30% of global oil production. Similarly, the region contains 40% of proved gas reserves and 18% of global gas production.1
The shape and duration of any war is always highly unpredictable with many different scenarios that could negatively impact the global economy and markets. In this case, a more limited war between Israel and Hamas would seem to pose negligible worldwide economic risks. However, escalations involving Iran, or other oil producing states, would likely increase the risk of much larger disruption to global energy markets with potential recessionary implications for the world economy should the disruption be material and longer lasting.
The conflict also comes at a time when the oil market is already in a tighter condition as global oil demand is scaling record highs yet supply growth has been limited due to voluntary production cuts from Saudi Arabia and reduced production targets from OPEC+.2 Clearly this is not lost on markets as prices per barrel have risen 30% since summer. And while spare production capacity does exist, a sustained and wider regional conflict could easily see oil prices revisit $120+/barrel which was the uncertainty premium we observed in the early days of the Russia/Ukraine conflict.
Meanwhile, the backdrop for the global economy isn’t overly encouraging as most developed economies are still dealing with the twin shocks of higher inflation and higher interest rates. Add-in the complexities of geopolitical risks stemming from two wars, ongoing risk of recession in the U.S. and Europe coupled with a slow-down in China, and one can understand the vulnerabilities that exist for the global economy today.
Many analysts have referenced the Arab-Israeli War of 1973, which triggered a sharp drop in oil production coupled with the Arab oil embargo resulting in a quadrupling of oil prices. As we know, this contributed to the combination of higher inflation and lower growth worldwide, more commonly known as stagflation, for the U.S. and several other developed economies.
While we certainly should expect upward pressure on oil prices due to increased uncertainty, the combination of events that led to the dramatic increase in oil prices during the embargo will likely not be repeated for several reasons. First and foremost, oil as a share of overall energy demand has declined from 50% to 30% over the past 50 years (think greater energy efficiency and renewables) and OPEC’s share of the global oil market has dropped 30% over the same period (think U.S. shale revolution).3
Additionally, Israel’s relations with Arab states are much less confrontational today particularly with Saudi Arabia, by far the region’s largest producer. The recently signed Abraham Accords along with less unity in the Arab world are all key considerations here. And one last important variable is currency, given that oil is priced in U.S. dollars. In the 1970s, we saw a large depreciation of the U.S. dollar which was a central factor as a sharply declining dollar, all other things constant, normally means sharply higher oil prices.
So, economic and political conditions are different today, and we should view the 1973 instance as much more the exception than the rule. Not surprisingly, the key determinant of a material disruption in the oil market is whether or not supply producing countries are involved in the conflict. For example, in the past 50 years there have been several Israeli conflicts, two involving Gaza specifically, that did not meaningfully disrupt oil supplies and resulted in oil prices rising, on average, only 4% near-term.4
Geopolitical risks are part of the investment reality, and while markets are used to conflict in this part of the world, these situations are highly unpredictable and financial market conditions can change quickly. We are continuing to closely monitor how this conflict evolves but investors should expect higher volatility with more of the uncertainty expressed through energy markets.
In terms of the most pronounced market reactions so far, prices for crude oil and gold have risen roughly 5% to 6% while the MSCI Israel Investable Market Index has declined 15% since the attacks. Our direct exposure to Israeli equities in client portfolios today is roughly in-line with market weights ranging from 0.1% to 0.2% of the total portfolio.
Having a diversified investment portfolio with built-in shock absorbers such as bonds, diversifiers and defensive equities are key elements of our investment strategy and will help us weather geopolitical market impacts as well as provide a source of funds for attractive long-term capital appreciation opportunities.
1British Petroleum. Statistical Review of World Energy. August 2021.
2The Organization of the Petroleum Exporting Countries, also known as OPEC, was formed in 1960 by Iraq, Iran, Kuwait, Saudi Arabia, and Venezuela. In 2016, OPEC signed an agreement with 10 other oil-producing countries to create what is now known as OPEC+.
3The Conversation. “Rising oil prices surging inflation.” October 2023
4Bridgewater Associates. Daily Observations. October 2023.
5International Monetary Fund, IMF DataMapper 2023
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