Stocks fell on Friday in a rather measured fashion after American forces assassinated two top Iranian military leaders near Baghdad. Oil prices spiked higher and interest rates fell. Over the weekend, tensions remained high and the rhetoric on both sides escalated. As a result, futures are down again this morning. Note that stocks rose sharply in the fourth quarter. Thus, at least part of the pullback could be attributed to profit taking as the calendar rolled over into 2020.
The picture in Iran is unclear to say the least. The Iranians can hardly afford to fight an all-out war with the United States. The country has been spending months trying to limit protests against its government over a collapsing economy and the government’s persistent divergence of funds toward military and away from the economy. While it does have an able Army, it doesn’t have anything near a world class navy or air force. As for the U.S., President Trump has made it clear he wants to remove as many remaining troops as possible from the Middle East as soon as he can without totally destabilizing the region. Now, of course, that may not be possible.
While neither side wants war, both sides follow the Trump doctrine of hit me and I’ll hit you back harder. Perhaps that overwhelms the logic that war can be avoided. That certainly is a fear that has markets on edge. Although, I would caution that if you add Friday’s losses to the declines in futures in the early morning hours, they only total a bit over 1%.
One of the major concerns surrounds the meaning of the word “war” in this case. So far, nothing of a conflict nature has happened on either U.S. or Iranian soil. Oil facilities were attacked in Saudi Arabia. Tankers were attacked in the Persian Gulf beyond Iranian waters. The U.S. embassy in Baghdad was stormed and, of course, last week’s assassination took place in Iraq. Iran uses proxies like Hezbollah to carry out its dirty work away from Iranian soil. In many ways, governments of Syria, Lebanon and Iraq are under Iranian influence. Iraq, at the moment, is caught in the middle. It can’t push back too hard on Iran but it also knows that if the U.S. leaves, as it now claims, its independence from Iranian influence will decline.
So what is a future “war” likely to look like and how does that affect world economies? Iran by itself is not a major oil producer any more. Certainly, if its remaining exports are diminished, there will be some impact on oil prices. A move of roughly 10% so far, accounts for that. The military actions to date on both sides have been isolated and measured. Few lives have been lost. The death of two key leaders who have affected Iranian overseas military policy for about two decades leaves an obvious power vacuum that could take weeks or months to replace. That suggests that, despite Mr. Trump’s harsh rhetoric over the weekend, a quick military response from Iran may not happen as soon as some fear.
But “war” today isn’t the same as war before. During our revolution, soldiers were told not to fire until “you see the whites of their eyes.” We don’t fight wars that way anymore. Indeed as the decades and centuries passed, convention ground wars have changed. Until recently, roadside bombs took more lives collectively than cluster bombs or tanks roaming through the streets. We are highly unlikely to send massive forces to attempt a ground war in Iran, and Iran is even less likely to send forces here. But what can happen is that war tomorrow can take another major twist and evolve into something that involves no guns or bombs at all. Cyber warfare.
Both countries possess cyber capabilities. Iran could lean on the support of others hostile to the U.S. to aid any cyber mission. How any such attacks could be carried out remains a speculation, a space I have little or no capability to discuss. But my point is that a conventional war, focused on military actions and responses may not be a logical outcome. Indeed, the attacks of 9/11 changed the rules of confrontation dramatically. They also changed our everyday lives in many ways.
Every company in the world should be having meetings right now to review and strengthen, if necessary, their own cyber security capabilities. Indeed, many large corporations experience thousands of attempted intrusions every day. Our government should increase coordinated efforts with private industry to ensure the safety of power grids and other essential infrastructure. The enemy will always seek the weakest link as the port of entry. In a global integrated world, the small local electric company’s grid could be that weak spot. The range of possible disastrous outcomes is more a subject for Hollywood film writers than a stock market strategist.
Directly, few companies are affected by last week’s actions. Oil stocks are up as oil prices spike but, ultimately, supply and demand forces will dictate whether prices remain elevated. Reducing Iranian production alone won’t sustain today’s prices. Defense stocks are up as war fears are elevated, but we are probably not headed for conventional war. As just noted, if there is any elevated spending in the near future, it would be in the cyber arena.
Stocks should eventually settle down if there are no direct responses in the near future. But it would be foolish to expect Iran to do absolutely nothing in the months ahead. Last week’s events don’t require an immediate response. Iran could wait and see world reaction. The U.S. is attempting to make the case necessary to justify its actions. Support from our traditional allies so far has been muted. Iran could seek to use that as a wedge for their benefit. Mr. Trump has to be careful that cyber or non-military retributions don’t damage his reelection bid. Thus, there are more question marks than answers today and that is why investors remain on edge.
At the same time, nothing has happened so far to change our economic equation. No earnings estimates have been adjusted and a slight decline in interest rates is probably a positive for equity markets.
Perhaps the big takeaway is that the events of last week were merely a trigger for profit taking in general. A 3-5% pullback without any direct cause, would probably be constructive and a 10% pullback wouldn’t be out of the question. We know over the past few years that corrections can be both sharp and quick. If volatility escalates, all sorts of trading algorithms get set off and declines could steepen. That isn’t a prediction quite yet but if a sub-1% daily drop suddenly escalates to a 2-3% move, fear will rise rapidly as traders and weaker hands run for cover. Without any intervening event that justifies such a pullback on an economic basis, a correction of this magnitude should be viewed as a buying opportunity.
Today, Eric Trump is 36 as is Saturday Night Live’s Kate McKinnon. Remember Mr. Bean? Rowan Atkinson is 65 today.
James M. Meyer, CFA 610-260-2220