War and asset prices

Good morning. After the events of the past few days, the world seems dangerous and confusing, and it is natural to seek clarity from every available source. But, I argue below, markets provide little insight at moments like this. Disagree? Send me an email: [email protected].  

Markets and war 

To start with a brief statement of the obvious, the movements of markets are of trivial importance compared with the value of human life. Financial commentary is therefore a small sidebar to the story in Israel and Gaza. But it is what we do here at Unhedged. 

With that said, the geopolitical risk environment changed over the weekend in a significant way. As many commentators have pointed out, the implications of the war between Israel and Hamas could well reach far beyond the region, to the US, China, Ukraine and Russia. All of this could make big differences to the prices of real and financial assets over time. The uncertainties, however, are overwhelming.

At moments like this, there is a temptation to think that the great collective weighing machine known as the market might offer important insights into what is going on and what might happen next. “What is the market telling us?” becomes a common refrain. This temptation ought to be resisted. I have never seen evidence that markets are particularly good at gauging geopolitical risk (which is why the market rewards for good geopolitical judgment can be so high). And so I don’t think there is much to learn from the market about the implications of the latest war in Israel — even its financial implications.  

Yesterday’s action in the oil market, the one most directly implicated in the conflict, is a good example. Brent crude rose by almost $4 a barrel, or 4.5 per cent to $88. Not only is that only a “medium daily gap up” in oil prices, as Rory Johnston of Commodity Context put it to me. It looks smaller still in the context of the $11 drop in prices of last week. In the absence of a war, the day’s move might have looked like a normal rebound. 

Does the muted move make sense? Does the war create only a smallish risk of higher oil prices, on balance? That doesn’t seem quite right.

Two main risks have the attention of oil watchers right now. The larger of the two is that Iran could be implicated in the planning or execution of the attack on Israel, leading to tighter international enforcement of sanctions and reducing Iranian oil exports. Iranian shipments have risen in recent months, despite sanctions, leading to some speculation that the US is taking a relaxed attitude towards sanctions enforcement. Johnston provides this chart, showing an increase of about 1mn barrels a day since the low point early 2020: 

If this increase were to be reversed, and a million barrels pulled out of the global market, the impact on prices, both in level and in volatility, would likely be significant, given that the market is already tight. The duration, not just the amount, of the decrease would matter too. If that million barrels were not replaced by new production elsewhere, Johnston says, oil at $100 would make sense, especially as the medium-term trend had been upwards already and speculative positioning was already bullish. But we don’t know how to quantify the risk that Iranian involvement will be proven and punished (The Wall Street Journal has reported that Iran helped in the planning of the attack; other outlets have not confirmed the story). 

The second risk is that tensions in the region push Saudi Arabia to sustain its current production limits. It had been reported that the Saudis would be willing to increase output to help secure normalised relations with Israel. The prospect of normalisation seems a lot dimmer than it did a few days ago but, again, the odds and the timing are up in the air. 

Admittedly neither of these two risks seem likely, in themselves, to create a price shock (and ensuing inflationary crisis) comparable to the one which followed the Yom Kippur war and the oil embargo. As Jason Bordoff, director of Columbia University’s Center on Global Energy Policy, explained to me, “today is not like 1973”. He noted that there are more strategic oil reserves globally, more diversified sources of supply, a functioning and liquid futures market, and a global strategic planning forum, the International Energy Agency. All of this makes the market more adaptable and stable than it was 50 years ago.

Still, less probable but more severe tail risks that have to be considered as well. As Andrew Gillick of Enverus pointed out to me, an outright military conflict involving Iran could lead to much larger disruptions, including but not limited to the closure of the Strait of Hormuz. Are there extreme, unlikely, but non-trivial scenarios priced in? How would one know if they were?

Very significant new risks were, without question, introduced to the oil market over the weekend. But these risks are highly complex and hard to define. So the market, not knowing what to do, did essentially nothing. So looking at the oil market tells you very little about how the geopolitical risk environment just changed.

It is possible that today’s small move in oil represents the results of a complex collective exercise in scenario analysis and risk weighting. Perhaps some efficient markets hypothesis extremist believes this to be so. What seems more likely, however, is that the oil market is in the dark with the rest of us, responded with a small risk-off twitch, and then carried on as before.  

Other markets, it is worth noting, echoed oil’s muted response yesterday. Gold and the dollar, those traditional safe havens, edged up. Energy and defence stocks rose, but mostly global equity markets responded with a shrug, despite the inflationary implications jumped in oil prices, which could have significant implications for valuations and profits. In the options market, where one might expect to find investors busily hedging to protect their gains of recent years “The equity volatility response [on Monday] was relatively muted despite the news,” Amy Wu Silverman of RBC writes. She thinks part of this is down to the fact that, with the Treasury market closed, rates couldn’t scare everyone. Another factor is that the magnificent seven megacap tech stocks have continued to function as a haven for equity investors, and given their size, it is hard for the market to panic when the seven do not. But more generally, she cautions, “the options market is quite bad at pricing geopolitical risks”.

The market, under ordinary circumstances, is the best mechanism for allocation of resources and is, more often than not, a remarkably good estimator of asset values. It does not understand wars any better than the rest of us do.

One good read

A Financial Times interview, from last year, with Claudia Goldin, the latest Nobel laureate in economics.