Mumbai: Investors must brace for sharp swings in equities early this week as the unexpected escalation of the decades-long conflict between Israel and Palestinian militant group Hamas has heightened geopolitical risks for the market. While markets across the globe, including Dalal Street, could react adversely Monday morning, the extent of the fallout in the days ahead will depend on the involvement of countries such as the US and Iran in the conflict, and the direction of oil prices.
Stocks in Israel and the Middle East dropped on Sunday in response to the heightened tensions in the region. Israel equities plunged 5.8% at the time of going to print. Saudi Arabia was down 1.7%, while Kuwait and Qatar markets were trading weak.
Oil on Boil?
All eyes will be on oil prices when they open for trading on Monday morning.
“The main element of the new geopolitical risk is oil,” said S Naren, CIO, ICICI Prudential Asset Management. “If the increase in oil prices on account of the event is not substantial, India will not have much of a problem because its economic fundamentals are strong. But, if oil prices rise substantially, it will not be good news for investors then.”
Some in the market expect the surge in oil prices in reaction to the geopolitical concerns to be limited, unless the US and Iran become parties in the conflict. Iran, a key backer of Hamas, is a major oil producer. Markets are watching if the US and other developed countries put fresh restrictions on Iranian oil exports as a fallout of the conflict. Israel itself is not a big oil producer.
“Much will depend on whether the crisis turns out to be another short-term flare-up or something much bigger like a war between Israel and Iran,” said Ed Yardeni, founder and chief investment strategist at Yardeni Research, a New York-based investment consultancy. “That’s unlikely, but today’s conflict will only escalate the tensions between these two adversaries. The price of oil may be a good way to assess the likelihood of a broader conflict.”
Concerns over the recent surge in oil prices to over $90 a barrel, along with the spike in the US bond yields and the dollar, have sparked so-called risk-off sentiment across Emerging Markets (EM),including India, in the past three weeks. Specifically for the Indian economy, higher crude prices are bad news as it imports more than 80% of the crude it requires.
Elevated Risk-off?
While Brent crude futures have shed a portion of their gains to $85, a rebound will unnerve investors amid worries that rising gas prices would keep inflation in the US sticky for a longer period, which in turn could force the US Federal Reserve to increase rates further. Elevated interest rates in the US make Indian equities less attractive for investors there.
“Geopolitical risks have further complicated the situation in the financial markets and in the US economy,” said Ritesh Jain, co-founder, Pinetree Macro. “If oil prices go up further, US inflationary pressures would remain and cause US bond yields to cross 5%. That will not be taken kindly by the markets.” On Friday, the yield on the US 10-year benchmark Treasury bond briefly rose to 4.88%, its highest level since 2007.
Geopolitics and Indian equities
Investors in mid-cap and small-cap stocks have more to worry if the geopolitical risks affect Indian markets.
“I would be more worried about the mid-cap and small-cap space if the geopolitical situation blows out of control,” said Naren. “The bigger concern in the market is retail investors’ unwavering conviction in mid-cap and small-cap stocks, whose valuations are above comfortable levels.”
Rich market valuations give little room for disappointments in the market.
“If the stock market was cheaper, the potential impact of this (geopolitical concerns) would have been moderate,” said Jain.
