Israel strikes Iran. Are markets anticipating an escalation?

Executive summary:

• Israel retaliated against Iran with a limited military strike
• Historically, most market reactions to geopolitical events are short-lived
• China surpassed its expectations for first-quarter GDP growth
• China tightened restrictions on IPOs

On the latest edition of Market Week in Review, Director and Investment Strategist Alex Cousley and ESG and Active Ownership Analyst Zoe Warganz discussed the market’s reaction to the Israel-Iran conflict. They also chatted about the latest economic data in China and recent actions taken by the China Securities Regulatory Commission.

Israel retaliates against Iran

Cousley said that early on April 19, Israel retaliated against Iran for its April 14 attack, carrying out a limited military strike against Iran. After the U.S. confirmed the strike, both Israeli and Iranian media downplayed the severity, with a retired Israel general labeling it a ‘symbolic attack’, he noted. “Early indications suggest that Iran does not see an immediate need to respond, but we will be closely monitoring events over the weekend as the key risk remains some form of escalation, which would weigh on market sentiment in the near term,” Cousley said. He stressed that any potential Iranian response, as well as any risk of disruption to oil flowing through the Straits of Hormuz, will be key watchpoints.

How do geopolitical events typically impact markets?

Historically, Cousley said that most geopolitical events typically see fairly modest reactions in markets, with a median drawdown of 3% in the benchmark S&P 500 Index dating back to 1941. In addition, geopolitical-driven equity selloffs are typically short-lived, he said, with the S&P 500 generally recovering its losses in less than a month. However, there have been a few notable exceptions to this over the past several decades, Cousley said, including the Yom Kippur War and subsequent OPEC oil embargo in 1973 – back when the U.S. was a major oil importer.

How are we positioning our portfolios amid the conflict?

Cousley stressed that when the Israel-Iran conflict broke out, the Russell Investments team already had concerns about equity market valuations and sentiment, which was starting to look overbought. That sentiment has moderated following equity market weakness the week of April 15, he said, but has not returned to neutral readings.

“At Russell Investments, our exposure to duration will likely benefit from any further decline in Treasury yields if escalation leads to a risk-off scenario,” Cousley stated. He added that if markets do sell off aggressively in reaction to any escalation and signs of oversold sentiment or panic start to appear, that could be a catalyst to incrementally move from a slightly defensive positioning to neutral.

As of April 19 at 7 a.m. Pacific time, markets were down approximately 2% on the week, he said, with government bond yields slightly higher. “The reaction in fixed income markets is not typical, as yields typically rise during geopolitical events, with investors flocking to the safety of bonds,” Cousley remarked. “There are other things that have been driving markets more lately – in particular, the release of another round of stronger-than-anticipated U.S. economic data,” he remarked.

Increase in exports powers Q1 growth in China

Shifting to China, Cousley noted that the world’s second-largest economy recorded a 5.3% increase in GDP (gross domestic product) in the first quarter from a year earlier. “This was a better-than-expected number, and a fair amount of this can be attributed to an increase in exports as the global manufacturing cycle improves,” he explained.

A look further under the hood, however, shows that domestic demand in China is still soft, Cousley stated. Case-in-point: retail sales, credit demand, corporate demand and consumer-mortgage demand were all softer than expected during March, he noted.

Another recent development in China was the China Securities Regulatory Commission’s (CSRC) announcement of new directives around stock issuance, Cousley said, explaining that the CSRC typically does this about once in every 10 years. The latest guidance tightens rules around IPO issuance and follow-on issuance, he said, with the hopes of better protecting investors and improving equity returns.

“Over the past 20 years or so, China’s economy has been very strong – yet equity-market returns haven’t been nearly as robust, largely due to the dilution of shareholder returns. By tightening the rules around stock listings – for example, by restricting the ability of companies to go public if they’re not in a strong position to do so – the CSRC is trying to close this gap,” Cousley said.

He noted that small-cap Chinese stocks sold off in the wake of the news, mainly because smaller companies are more likely to IPO – or become publicly traded – in China. Cousley said he expects additional volatility in the short-term due to questions over how these measures will be implemented, as well as ongoing uncertainty over China’s economic backdrop. However, he stressed that in the long term, the new rules are likely to benefit investors as the quality of public companies improves.