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What a US-Iran war could mean for world markets

Heidi Chung

The U.S. confirmed that a top Iranian general was killed in Iraq Friday by an American drone strike ordered by President Donald Trump. Geopolitical escalation and conflict is expected in the region.

For investors, however, the main question remains how a war between the U.S. and Iran would impact markets.

“Gold’s a winner as tension increases, and oil prices are higher too,” Societe Generale’s Kit Juckes wrote on Friday morning. “Bond yields are lower, the equity rally which was underway in the U.S. has stalled but not gone dramatically until reverse, and in the FX market, safe havens and oil-sensitive currencies benefit but it’s the yen which is the clear winner.”

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Tensions have been ratcheting up between the U.S. and Iran for some time, but the killing of Iranian Major General Qassem Soleimani is being seen as the main catalyst for a potential war between the two nations. The attack was met with strong words of “forceful revenge” from Iran’s supreme leader.

“Iran must respond. This is potentially the most destabilizing event in the region since [the U.S.] invaded Iraq,” Academy Securities wrote in a note Friday. “Shia Mobilization forces will undermine the Iraqi government by targeting U.S. forces and Iraq’s government won’t be able to control the chaos. It has changed the narrative in Iraq from a weak government - recent protests at the U.S. Embassy - to ‘down with America’ and a violation of sovereignty.”

Consensus among analysts is that conflict will ensue between the U.S. and Iran, but how long it will last and how destabilizing it will be remains to be seen.

“The Iranian actions will stop short of what we would consider war,” Eurasia Group said in a note Friday. “Overall, the chance of war is 40%. We divide war into two sub-scenarios: a limited conflict (intense fighting for a week and at least 100 dead) and a major conflict (region-wide conflict that would last several months and involve sustained attacks on regional oil infrastructure). Under the 40% war scenario, a limited conflict has a 70% probability and a major conflict a 30% probability.”

So how would escalation and prolonged conflict affect markets?

Pantheon Macroeconomics’ Chief Economics Ian Shepherdson explained, “the wild card is whether turmoil in the Middle East triggers a sustained sell-off in equities, depressing business and consumer confidence to the point where labor market and inflation concerns become secondary. We'd be surprised—the plunge in S&P futures right is just the initial knee-jerk response—but if Iran takes more drastic action than we are expecting, it will become a real risk.”

Pakistani demonstrate over the U.S. airstrike in Iraq that killed Iranian Revolutionary Guard Gen. Qassem Soleimani, in Peshawar, Pakistan, Friday, Jan. 3, 2020. Iran has vowed "harsh retaliation" for the U.S. airstrike near Baghdad's airport that killed Tehran's top general and the architect of its interventions across the Middle East, as tensions soared in the wake of the targeted killing. (AP Photo/Muhammad Sajjad)
Pakistani demonstrate over the U.S. airstrike in Iraq that killed Iranian Revolutionary Guard Gen. Qassem Soleimani, in Peshawar, Pakistan, Friday, Jan. 3, 2020. (AP Photo/Muhammad Sajjad)

Shepherdson noted that if drastic action from Iran becomes the situation, the Federal Reserve might have no choice but to ease monetary policy.

“In the meantime, expect defensive stocks to outperform, with downward pressure on Treasury yields and gains for safe-haven currencies, until Iran's response becomes clear. To repeat: Iran will respond,” he added.

“The yen’s our top FX pick for this year, but because we think we’ll see new lows in bond yields, and more Fed easing than most expect, rather than because we expect a whole year or geopolitical tension,” Juckes said. “From here, the key level to watch is probably EUR/JPY 120, the bottom of the upward-sloping channel the pair’s been in since global bond yields turned high in September. That probably holds unless there is further escalation.”

Heidi Chung is a reporter at Yahoo Finance. Follow her on Twitter: @heidi_chung.

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