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An unshocking response to the Saudi oil supply shock?

Sep 20, 2019 | Kelly Bogdanova


An escalation of military tensions in the Middle East would likely grab the market’s attention. We assess how geopolitical risks could impact portfolios

One of the world’s largest oil producers loses more than half of its output after drones and missiles penetrate its very expensive missile defense system, and just days later crude oil has retreated meaningfully from its spike and equities are nearly where they were before the attack. What gives?

Acts of war, terrorism, and the like don’t always move markets, and there are key reasons they are responding calmly to the strikes on Saudi Arabia at this juncture. But if military tensions escalate, especially if the U.S. becomes involved, markets may take notice. RBC Capital Markets’ commodity strategy team thinks “risks are high and that this conflict goes kinetic before year-end.”

With geopolitical uncertainties on the rise and conflicts in the Middle East unlikely to disappear anytime soon, we think it’s useful to gauge how military clashes have impacted the U.S. equity market previously, and to consider how such risks should be factored into portfolio positioning.

Rolling with the punches …

Saudi Arabia, with the third-largest military budget in the world behind the U.S. and China, spent billions upon billions of dollars purchasing extensive missile defense systems to shield its key infrastructure, especially its Abqaiq crude oil processing facility, which was a well-known target, according to our commodity strategy team.

Nevertheless and for whatever reasons—there are various explanations by military hardware experts—the expensive missile defense systems left the Kingdom’s infrastructure extremely vulnerable. And it wasn’t the first time.

The calm, measured market reaction to the Saudi energy infrastructure attack isn’t unheard of compared to previous hostile acts. Some military and terrorism events move markets, others don’t, and sometimes markets take a “wait-and-see” approach.

… but events can change

In this case, markets seem to be taking the risks in stride because Saudi Arabia believes it can fully restore oil production by month’s end, and in the meantime it is releasing strategic reserves to fill the gaps.

Markets are laser-focused on the global economy, and crude oil's relatively tame reaction (as the initial shock to prices dissipated) means global consumer spending is unlikely to be impacted by this specific incident.

Another reason for markets’ restrained reaction is that so far President Trump seems to be doubling down on sanctions against Iran rather than prioritizing a military option.

But priorities and events can change, especially in the Middle East where war and terror is the norm rather than the exception. Tensions between Saudi Arabia and Iran, the war and humanitarian crisis in Yemen, and the related entanglements of the U.S. and other countries in the region are unlikely to flame out anytime soon. Not everyone in Washington seems intent on merely stopping at sanctions. Some are beating the war drums again.

Also, sanctions can be a slippery slope. Once a country has been sanctioned to the hilt with little prospect of relief, what incentive does it have to cooperate?

History lesson

If tensions in the region heat up further, we think the market’s performance during previous military conflicts and hostile acts can serve as a guide to the potential range of outcomes.

The S&P 500 fell 6.3%, on average, in 17 major post-WWII military conflicts and security events that we evaluated. The market’s reaction lasted an average of only 30 days. At times equities weakened during the run-up to the conflict as tensions were mounting, and recovered soon after it began. (See the full list along with terrorism events in the table.)

S&P 500 responses to select acts of war and terrorism since World War II
Events Start date Trading days to trough % change to trough Trading days back to even
Acts of war
U-2 shot down; cover unwound May 7, 1960 2 -0.6% 4
Bay of Pigs invasion Apr 15, 1961 6 -3.0% 14
Cuban Missile Crisis Oct 16, 1962 6 -6.3% 13
Gulf of Tonkin Incident (Vietnam) Aug 2, 1964 4 -2.2% 29
Tet Offensive (Vietnam) Jan 29, 1968 25 -6.0% 46
Cambodian Campaign (Vietnam) May 1, 1970 18 -14.9% 86
U.S. invades Grenada Oct 25, 1983 11 -2.8% 15
Lead-up to U.S. Panama invasion Dec 15, 1989 2 -2.2% 8
Lead-up to Gulf War (Desert Storm) Jan 1, 1991 6 -5.7% 13
U.S. spy plane captured in China Apr 1, 2001 3 -4.9% 7
War in Afghanistan Oct 7, 2001 1 -0.8% 3
Lead-up to Iraq War Feb 5, 2003 24 -5.6% 28
N. Korea invades S. Korea Jun 25, 1950 15 -12.9% 56
Lead-up to Six-Day War (June 6) May 14, 1967 15 -5.6% 20
Yom Kippur War, Arab oil embargo Oct 6, 1973 42 -16.1% 6 years*
Soviet-Afghan War Dec 24, 1979 7 -2.3% 10
Iraq invades Kuwait, oilfields seized Aug 2, 1990 50 -15.9% 131
Average 14 -6.3% 30
U.S. Embassy in Iran seized Nov 4, 1979 3 -1.0% 6
U.S. Marines killed in Lebanon Oct 23, 1983 12 -2.5% 15
Oklahoma City bombing Apr 19, 1995 1 -0.1% 3
U.S. Embassy bombings in Africa Aug 7, 1998 5 -2.5% 7
WTC, Pentagon airplane attacks Sep 11, 2001 5 -11.6% 19
Madrid train bombings Mar 11, 2004 3 -1.7% 5
London Underground bombings Jul 7, 2005 No S&P decline; FTSE -1.4%
Paris Bataclan, restaurant attacks Nov 13, 2015 1 -1.1% 2
Bastille Day attacks in Nice Jul 14, 2016 1 -0.1% 2
Average 4 -2.6% 7

* Other economic and monetary policy factors negatively influenced the number of days it took the market to get back to even; this is not counted in the average number of trading days back to even.

Source - RBC Wealth Management, RBC Global Asset Management, Wikipedia, National Security Archive at George Washington University, U.S. Naval Institute; data attempts to capture any pre-event impact

But like any small sample size, there were notable deviations, some of which are segmented in red in the table. In these cases, markets were not immune from volatility and meaningful losses. Some events sparked 10%+ corrections and negatively impacted the U.S. economy.

In our view, the state of market and economic fundamentals at the time, and the subsequent impact on economic momentum after the geopolitical shock occurs, go a long way in determining how acute and long-lasting the market’s reaction will be following a clash.

Portfolio perspective

In determining equity allocations, we believe investors would be prudent to assume that geopolitical risks can crop up occasionally and push the equity market into a temporary 5%–10% pullback or, in rarer cases, an even longer-lasting correction of greater magnitude.

If an investor’s current allocation to equities cannot be sustained through these types of declines then there may be a mismatch between the equity weighting and liquidity needs, risk tolerance, or time horizon that should be addressed. Funds earmarked for equities should be long-term allocations given the steep swings the equity market can (and usually does) have in a variety of circumstances.

As with any outside event, we focus on the potential economic and earnings impact, as these are the primary factors that drive equities over the medium-to-long term. As long as the trajectories of the global and U.S. economies and corporate profits are not materially threatened by the current geopolitical dispute in the Middle East, we are comfortable holding equities at the Market Weight or benchmark level in portfolios.