When a market melt-up is built on pure hope rather than fundamentals — as was the case for stocks closing out 2019 — one event that dents the very driver of said hope could dramatically shift risk sentiment in equities for an extended period.
Investors are about to be reminded of that often painful lesson.
Dow Jones Industrial Average futures tanked more than 350 points on Friday. Gold prices spiked to a four-month high, and oil prices sniffed $70 a barrel following the U.S.-led killing of Iran’s top commander. General Qassem Soleimani was killed in a U.S. drone strike in Baghdad, the Pentagon confirmed Thursday night. Soleimani, a major player in Middle East politics, led a special forces unit of Iran’s Revolutionary Guards. He was reportedly involved in recent U.S. embassy attacks in Iraq and been plotting other attacks against U.S. interests in the region.
Experts believe Soleimani’s killing will ratchet up already terrible U.S. relations with Iran, in large part fueled by tough American sanctions on the country. A response by Iran to Soleimani’s death is seen as inevitable — what is unclear is if any action would hurl the country into a military conflict with the U.S. and its allies that would harm global growth.
“The Iranian actions will stop short of what we would consider war. Overall, the chance of war is 40%,” said Eurasia Group strategist Henry Rome. “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.”
That’s hardly comforting.
As for investors, the rising tensions with Iran shouldn’t be completely disregarded as a one day event. Remember, the record-setting stock market gains of 2019 — and strong start to 2020 — has been powered by hope – in part by hope that the U.S. economy rebounds in 2020 amid a more certain outlook on the trade war. And hope that earnings growth from Corporate America will hit 10% — or more — on the back of low inflation, low oil prices and low rates from the Federal Reserve.
Valuations on America's biggest companies have surged past historical norms, even as there have been limited – to no – signs of improved economic growth in the U.S.
For example, reads of the health of U.S. manufacturing have been mixed at best. In turn, it’s likely warranted that some of this blind hope in markets is unwound in the form of profit-taking. It’s unlikely investors have appropriately priced in rising geopolitical risk (which could include much higher oil prices if Iran tries to close the Strait of Hormuz) into their outlooks for 2020.
“Clearly, the major concern for the world economy is that events spiral out of control and the U.S. launches a full-blown military assault on Iran,” said strategists at Capital Economics. The firm estimates a U.S.-Iran war could shave off about 0.5% from global GDP.
Meanwhile, Credit Agricole SA strategist Valentin Marinov wrote in a note to clients the killing of Soleimani could squash hopes for a rebound in the global economy.
So much for that hope.