Assessing Potential Market Impact of Israel-Hamas War

On Saturday, Hamas, a Palestinian militant group designated as a terrorist organization by the U.S. government, launched an attack on Israel, killing hundreds of civilians and taking dozens more hostage. In response to the attack, Israel launched a counteroffensive on Hamas positions in the Gaza Strip (one of two Palestinian territories, the other being the West Bank), a territory home to 2.3 million Palestinians under Hamas rule.

While volatility initially impacted markets to start the week, investors seemingly shrugged off the tragic geopolitical turmoil in the Middle East, with the S&P 500 closing up 0.3 percent Monday. This market reaction may reflect the view that the conflict will remain focused on just Gaza and Israel, rather than spreading into oil producing regions throughout the Middle East. The market response is also likely looking at any potential for a slowdown in the global economy as increasing the likelihood of a pause in the Federal Reserve’s (Fed) interest rate hiking cycle.

Stock Market Performance Following Prior Geopolitical Events

So, how have markets historically reacted to geopolitical crisis events, including wars and terrorist attacks? We look back at two dozen or so such events going back to World War II in the table below:

As you can see above, the average one-day return at the onset of a geopolitical event is -1.1%. The S&P’s 0.3% gain Monday was unusual compared to history, as a positive one-day return only occurred four out of the 23 events we studied.

While the total drawdown related to this tragic event and recovery timetable are unknown, based on prior geopolitical events, the average drawdown is -4.7%, while the average time to reach market bottom is 19 days, and the average time to fully recover losses is 42 days. In other words, equities have historically held up well during geopolitical shocks, including wars and other military conflicts going back decades, with the average recovery taking roughly two months. Even the market recovery from 9/11 took only 31 days.

Looking at a slightly wider list of events that also includes major non-war related historical events and how stocks performed over the next year after the event it seems that the main determinant of returns is not the severity of the event but whether the event coincided with, or caused, a recession. Assuming no imminent recession, LPL Research’s base case scenario currently, history shows that markets are roughly flat over the next month following an event but on average recover in the following three, six, and 12-month periods. In the case of an event near a recession however stocks are down on average over all the time periods studied (one, three, six and 12-months).

Impact on the Path of Interest Rates

The weekend attacks on Israel affected markets’ expectations for the path of interest rates. On Monday the market implied probability of an increase in the fed funds target rate next month fell below 14% (after being almost 50% at the start of September and 30% last week) as investors anticipate the conflict has the potential to put a brake on the global economy this quarter. Despite a strong headline payroll report on Friday, wage pressures eased, adding support to markets’ view that the Fed will keep the target rate unchanged when the FOMC meets on November 1. Recent comments from Fed officials have also pointed in that direction by acknowledging the markets have done some of the Fed’s work by pushing yields on the intermediate and long parts of the Treasury curve higher. Interest rate sensitive sectors such as technology, communication services and utilities were amongst the bigger outperformers on Monday as expectations for further hikes in 2023 diminished.

Impact on the Energy Sector

Crude oil prices are on hyper-alert for any indication the conflict is poised to spread into the oil producing regions in the Middle East, particularly with regard to Iran. Initial reports suggested Iran supported and helped with logistics of the attack on Israel, but Iran denies having any role. Iran is suspected to be wary of recent progress that had been made toward a historic peace deal between Israel and Saudi Arabia that would reshape political power dynamics in the Middle East. The U.S. is involved in a broad reaching diplomatic effort to keep the conflict contained. Oil prices, however, may move dramatically higher if it appears the diplomatic effort is failing, and Iran is brought into the conflict.

Crude oil prices had been oversold coming into this week, but with a headline driven market sometimes filled with rumors and inaccurate reporting, oil prices can be subject to significant swings. Any chatter that Israel, now seemingly focused on shutting down Hamas’s operations, is preparing to strike beyond the immediate conflict, will escalate upward pressure on prices.

The first place markets will see the impact of fighting in Israel will undoubtedly be the increased risk premium embedded in oil prices, which would be expected to support the energy sector as markets assess the likelihood that Iran is brought into the conflict. Unsurprisingly the energy sector had the largest outperformance on Monday with a daily return of over 3.5%. LPL Research maintains its overweight recommendation on the energy sector.

Impact on Equity Positioning

The potential impact on the broader equity markets is difficult to predict because the risk of a wider conflict involving Iran or other countries in the region is still difficult to assess. Still, that risk, especially if it did materialize, could push volatility higher (although the volatility index, or VIX for short, actually ended Monday only marginally higher than Fridays close), sending stocks lower, and perhaps shift market leadership more toward defensives (utilities, gold, Treasuries, etc.). To be clear, this is not our base case.

If conflict remains contained to Israel and Gaza, while the humanitarian impact will still be devastating, the market impact will likely be very limited as Israel contributes only about 0.5% of world gross domestic product (GDP) and not a major producer of crude oil.

Defense stocks should catch a bid as defense spending will likely increase if this news provides a catalyst for Congress to act to bolster supplies of munitions and air defense systems that are now being supplied to both Ukraine and Israel.

The Strategic and Tactical Asset Allocation Committee (STAAC) maintains its neutral stance on equities but will continue to watch developments in the Middle East closely to determine potential impact on the energy sector, the broader equity markets, and the path of interest rates.