How Geopolitical Risks Impact the Stock Market Rally

Worries about a possible Iranian counterattack on Israel contributed to the decline in stock prices for the week.

For the majority of the past year, investors appeared to be completely unconcerned with geopolitical risks.

As of Thursday afternoon in New York, analysts from Bespoke Investment Group have noticed a significant shift. They suggest that speculation about Israel potentially preparing for a military attack from Iran has caused a sudden and drastic change in the stock market.

Earlier in the week, Israel destroyed an Iranian consulate in Syria, causing crude oil prices to rise.

A warning has been issued by market analysts about the possibility of the volatile situation in the Middle East having a greater negative impact on stocks than a postponed start to the Fed’s interest-rate cuts. This could be an unusual case where geopolitical risks significantly affect the markets in the long term.

Steve Sosnick, the chief market strategist at Interactive Brokers, mentioned in an interview with MarketWatch that equity investors are not very skilled at evaluating geopolitical risk and its potential impact on markets. He also stated that this risk factor is often overlooked until it becomes an immediate concern, leading to potential overreactions in the market.

Although U.S. stock markets closed with gains on Friday, they experienced a sharp drop on Thursday afternoon. The Dow Jones Industrial Average fell by 530 points, marking its largest daily decline in over a year, as reported by Dow Jones Market Data.

On Friday, Treasury yields increased after remaining lower on Thursday, even though Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, suggested that interest rates may remain unchanged until the following year. According to Bespoke, the lack of significant movement in bond yields indicated that concerns about potential conflict with Iran, rather than changing interest rate expectations, were the primary reason for the decline in stock prices.

Given this, it is important to consider why stocks are now seemingly reacting to tensions between Iran and Israel, six months after the Israel-Hamas conflict began. Despite the initial dismissal of the Oct. 7 Hamas attack, the S&P 500 ultimately closed higher on Oct. 9, as per FactSet data.

According to Savita Subramanian, head of U.S. Equity & Quantitative Strategy at BofA Global Research, investors often do not react to geopolitical events because they typically do not have a long-term effect on company profits. In a report released following an attack by Hamas on Israel on October 7, Subramanian noted that unless these events impact the overall economy, any market downturn is usually temporary. This can create a chance for investors to benefit by purchasing stocks at a lower price after a 5% to 10% market decline.

Subramanian noted that significant global events like the Sept. 11 attacks and Brexit vote had only a temporary effect on markets over the past thirty years.

The impact of Russia’s conflict with Ukraine lessened as crude oil prices dropped from their high point of $130 a barrel. The Federal Reserve attributed supply chain disruptions due to the COVID-19 pandemic as the main cause of the inflation surge that affected the markets in 2022, while the Biden administration initially pointed the finger at Russia.

However, any larger-scale conflict in the Middle East between Israel and Iran may result in significant economic repercussions that could compel investors to take action.

A sudden increase in the cost of crude oil, particularly due to the significant production in the Middle East, could cause significant problems. Although the abundance of crude oil in the United States may mitigate the impact on American consumers, it may still negatively affect the profits of American multinational companies. This could be due to disruptions in global trade, decreased demand for international travel, and a weaker European consumer base if there is another energy crisis, potentially leading to a recession in Europe.

According to Subramanian, these factors could lead to a prolonged decline in global stocks, lasting more than just a few months.

Certainly, certain sectors of the market stand to gain, such as the defense and aerospace industry. The SPDR S&P Aerospace & Defense ETF XAR has seen modest growth of only 1.7% so far in 2024. Additionally, energy companies could see advantages from increasing crude oil prices.

Ed Yardeni, the president and chief market strategist of Yardeni Research, has consistently cautioned investors against underestimating the dangers of conflicts in the Middle East. He views the possibility of a regional war as a major threat to his generally optimistic market predictions.

Yardeni issued a new caution on Friday, stating that if the Israel-Iran tensions escalate into a larger conflict, the stock market performance in the 2020s could be similar to the poor performance seen in the 1970s.

Yardeni stated in a CNBC interview on Thursday that although geopolitical crises have traditionally been seen as buying opportunities, the ongoing crisis in the Middle East is worsening and not likely to improve.

On Friday, American stocks ended the day on a positive note, with the S&P 500 rising by 57 points, equating to a 1.1% increase, closing at 5,204. The Dow Jones Industrial Average also saw a 0.8% gain, while the tech-focused Nasdaq Composite COMP increased by 1.2%.

All three stock market indexes ended the week with losses, and the Dow had its worst performance in a year. The recent decline in stock prices has been attributed to increasing oil prices and higher Treasury yields.

Yardeni believes that the potential for a larger conflict in the Middle East poses a greater danger to financial markets than the Federal Reserve deciding not to change interest rates for the remainder of 2024.

“I am primarily focused on geopolitics. If the Federal Reserve decides not to decrease interest rates, it will not worry me as it aligns with my belief that the economy is strong,” he explained to CNBC.

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