Geopolitical Turmoil Threatens to Derail the Stock Market Rally

Concerns over a potential retaliatory strike from Iran on Israel were a factor in the drop in stock prices for the week.

Throughout most of the previous year, investors showed little to no concern about geopolitical risks.

When we reached Thursday afternoon in New York, analysts at Bespoke Investment Group observed a substantial change. They believe that the speculation of Israel getting ready for a military strike from Iran has led to a sudden and dramatic movement in the stock market.

Israel destroyed an Iranian embassy in Syria earlier in the week, leading to an increase in crude oil prices.

Market analysts are warning that the unpredictable situation in the Middle East may have a more severe effect on stocks than the delayed implementation of the Fed’s interest-rate reductions. This could be a rare scenario where geopolitical uncertainties have a substantial long-term impact on the markets.

Steve Sosnick, the chief market strategist at Interactive Brokers, stated in an interview with MarketWatch that equity investors often lack the ability to properly assess geopolitical risks and their potential influence on markets. He also pointed out that this type of risk is typically ignored until it becomes a pressing issue, which could lead to exaggerated reactions in the market.

Even though U.S. stock markets ended the week with increases on Friday, they saw a significant decrease on Thursday afternoon. The Dow Jones Industrial Average dropped by 530 points, the biggest daily decline in more than a year, according to Dow Jones Market Data.

Treasury yields rose on Friday after being lower on Thursday, despite Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, hinting at no interest rate changes in the near future. Bespoke noted that the stable bond yields were more likely attributed to worries about a potential conflict with Iran, rather than expectations of interest rate fluctuations, as the main cause of the stock price drop.

Therefore, it is important to understand the reasons behind the current response of the stock market to the tensions between Iran and Israel, which have escalated six months after the conflict between Israel and Hamas started. Despite initially ignoring the Hamas attack on October 7, the S&P 500 ended up closing higher on October 9, according to data from FactSet.

Savita Subramanian, who leads U.S. Equity & Quantitative Strategy at BofA Global Research, explains that investors usually do not react to geopolitical events as they tend to have minimal impact on company profits in the long term. In a recent report analyzing the effects of a Hamas attack on Israel on October 7, Subramanian pointed out that market downturns resulting from such events are typically short-lived unless they have a significant impact on the economy as a whole. This presents an opportunity for investors to capitalize on lower stock prices following a 5% to 10% market drop.

Subramanian stated that major international events such as the September 11 attacks and the Brexit vote have had only a fleeting impact on markets in the last three decades.

The effects of Russia’s confrontation with Ukraine decreased as crude oil prices fell from $130 a barrel. The Federal Reserve blamed supply chain disruptions caused by the COVID-19 pandemic for the inflation spike that affected markets in 2022, while the Biden administration initially blamed Russia.

Nonetheless, a potential major clash in the Middle East involving Israel and Iran could lead to significant economic consequences that may force investors to make decisions.

An unexpected rise in crude oil prices, especially from increased production in the Middle East, could create major issues. While the abundance of crude oil in the United States may help lessen the impact on American consumers, it could still hurt the profits of American multinational corporations. This could be a result of disruptions in global trade, lower demand for international travel, and a weakened European consumer market in the event of another energy crisis, potentially causing a recession in Europe.

According to Subramanian, these factors have the potential to cause a long-term decrease in worldwide stocks, extending beyond a short period of time.

Some industries, like defense and aerospace, are likely to benefit from the current market conditions. The SPDR S&P Aerospace & Defense ETF XAR has only grown by 1.7% in 2024. Energy companies may also experience advantages due to rising crude oil prices.

Ed Yardeni, the president and chief market strategist of Yardeni Research, has consistently warned investors not to overlook the risks of conflicts in the Middle East. He sees the potential for a regional war as a significant threat to his generally positive market forecasts.

On Friday, Yardeni issued a warning that if the tensions between Israel and Iran worsen and lead to a larger conflict, it could have a negative impact on the stock market in the 2020s, potentially resembling the poor performance seen in the 1970s.

During a recent CNBC interview, Yardeni mentioned that while geopolitical crises have historically been viewed as chances to buy, the current situation in the Middle East is escalating and is unlikely to get better.

American stocks closed the week on a high note on Friday, with the S&P 500 gaining 57 points, or 1.1%, to finish at 5,204. The Dow Jones Industrial Average also saw a 0.8% increase, while the Nasdaq Composite COMP, which focuses on technology stocks, rose by 1.2%.

At the end of the week, all three stock market indexes experienced decreases, with the Dow having its most disappointing performance in a year. The drop in stock prices has been linked to rising oil prices and increased Treasury yields.

Yardeni thinks that the possibility of a bigger conflict in the Middle East is more of a risk to financial markets compared to the Federal Reserve’s decision to keep interest rates unchanged until the end of 2024.

He told CNBC that his main focus is on geopolitics. He stated that he would not be concerned if the Federal Reserve chooses not to lower interest rates, as it is in line with his opinion that the economy is robust.