Gulf tensions sink market sentiment but the Dollar rebounds

And so it begins….

Geopolitical tensions have spiked in the Middle East. The barrage of missiles and drones has been shattering key state properties, critical facilities and essential utilities across Gulf nations since Saturday. Attacks and counter-attacks are now in their fourth day. 

Will the deadly shootout be contained any time soon? No one knows. Is there a plan after the sudden removal of another country’s leadership? Nobody knows that either. The risk of political chaos is real. While most financial prices are holding up, investor confidence is slipping.

The flare-up took everyone by surprise. There was hardly any advanced warning. Tourists were still mingling in Dubai’s shopping malls when missiles started raining on Iran. Businesses went trading as usual. Now, many visitors are trapped.

The lesson here is that under the present US Administration, the threat of a sudden political “surprise” has increased considerably. Last year, it was the Liberation Day tariffs. This year, the Maduro “extradition”, Greenland, and Iran are new Trump catalysts that will re-shape geo-politics and shake market confidence.

How did the market react?

Initially, investors thought that it would be a repeat of the brief Venezuela affair, where the country’s Number Two takes over soon after. Well, every country is different. This time, US/Israel’s engagement in Iran is likely to last longer as the country has more weapons to fight back. 

And, it is a nation in grief. Political undercurrents in Iran are highly unstable, and this will only increase uncertainties. Iran’s retaliation against Gulf nations is a symptom of this fluidity.

Astute readers would have seen the flare-up in energy prices, particularly crude oil and natural gas. The latter is rallying on the back of drone attacks on Qatar’s gas facilities, as the Gulf nation is one of the largest producers of natural gas. For crude, it appears to have broken the pattern of lower highs (see below).

Gold naturally advances due to a drop in risk sentiment. After spiking to $5,400 per troy ounce, prices have retreated somewhat. New all-time highs appear possible in the near term if Gulf instability sustains.

Stocks, however, would be under immense pressure. Investors and traders who are sitting on nice profits after a two-month rally would be sorely tempted to pocket the paper gains. The downside risk is growing, and there is no certainty that the current shoot-out will end this week. 

Already, stock markets in the Middle East are sagging. 

The Dubai Financial Market General Index (DFMGI) is correcting from its long-term highs. The city of Dubai has seen some explosive action. While limited, this will spook tourists, shoppers and businesses. Given how much equity prices have gone up since 2020, the risk here is not to be underestimated, especially if the airspace around the region is partially shut for an extended period of time. Business and consumer confidence take a long time to build up, but only a minute to shatter.

War is bad for business, period.

And that’s the short-term reaction. Should energy prices continue to go up, the second-order effect of the conflict would be higher global inflation and slower economic growth over the coming quarters. In other words, a potential repeat of the events back in 2022.

This will cause a sustained drop in consumer spending and lower corporate profits, and with it lower equity prices.

 

Rotation into defensive assets to intensify

About two weeks ago, I highlighted the potential of market turbulence (see here). In that piece, I noticed that. 

1. Chasing the market aggressively higher did not entail good risk-to-reward
2. Market turbulence may increase  

Indeed. On a day-to-day basis, I also noted the rotation in consumer staples (such as McDonald’s). If you take all these subtle – but firm – capital trends, it paints a picture of defensive capital positioning.

Given what is happening in the Gulf, this shift into defensive assets may intensify. 

An interesting reaction in the last two days in this: the USD is actually serving as a defensive asset again. If we look at USDCHF (CHF being the strongest currency around), the dollar is actually gaining ground. Prices rebounded through their near-term ceiling to 0.787.

GBPUSD, USDEUR, and USDJPY – all suggest the same trend too. The dollar is rising against all these currencies. 

Why? Perhaps the widening conflict may hit many emerging markets economically. In that case, traders prefer the greenback over the EM currencies. 

Not to forget is that in the early phase of the Ukraine conflict in 2022, the dollar surged substantially. Traders may be betting on a repeat of this too.

If dollar strength persists, a correction in commodity prices may happen since they are priced in USD.

Should we buy into a correction?

The big question, however, is whether we should buy into any sharp slip-up in the stock markets.

Remember the Trump Trade War last April? Investors who bought during the month-long sell-off bagged good gains in the following six months. Many stocks rebounded sharply highly. From tech stocks to consumer sectors, many companies reported good profits throughout the summer, which supported a big rally in equities.

If there is a sharp setback in the next few weeks, would it present the same opportunity? 

I wouldn’t discount this possibility. After all, equities were rallying hard in many countries before the current skirmish in the Middle East. Equity indices in Japan, Singapore, the UK, South Korea, France, and Australia are all at record highs since the start of the year. This ought to tell us something about the market sentiment. Bullish, but overbought. 

Perhaps the latest correction in the financial market is a much-needed reset, so as to give investors a chance to buy into the performing markets at better prices.  

Therefore, you should have a list of potential buys and watch to nibble if prices do slump to technically attractive areas.