The chief investment strategist and chief economist at Citi Global Wealth delves into the investment implications of the latest dramas in the Middle East.      

Citi Global Wealth predicts that financial markets will have immediately priced in a higher chance that conflict in the Middle East will widen. It expects higher risk premiums, following Iran's drone and missile attack on Israel last week. 

Tehran's move is a significant escalation of security risks in the region and an intensifying regional conflict, according to David Bailin, chief investment strategist and chief economist at Citi Global Wealth.

For global markets, the event was well-anticipated and the initial reports of casualties from the bombardment were few, Bailin said in a note. This may limit the response in financial markets. The largest impact of the conflict was always likely to be felt in the price of oil, Bailin said. He still expects financial markets to immediately price in a higher possibility of enlargement of the conflict through higher risk premiums.

Crude oil prices rose following news that Iran was going to fire its air assault. Afterwards, it was reported that Israel, along with the US, the UK, France, and other forces, had shot down the vast majority of the drones and missiles.  

Given the rapid timeframe for production and consumption of oil and related products, oil prices tends to move very sharply relative to actual supply impacts, Bailin said. As was the case following Russia’s invasion of Ukraine in 2022 and Hamas’s attack of Israel in late 2023, oil markets feared a larger supply disruption initially. These fears then faded as greater clarity over supply followed. While he cannot predict the future course of the Iran/Israel conflict, Bailin believes that there is a high probability that this pattern will unfold again. 

Bailin thinks the geopolitical risk to oil supplies suggests a greater need for investment in energy security – redundant energy supplies – even as energy demand is being satisfied by a new mix of energy sources. Russia and Iran depend on petroleum exports for revenue and, unlike the 1970s, the US has risen to become the world’s largest petroleum producer. A repeat of the energy rationing, inflationary recession of 1974 is therefore unlikely. 

Independent
Bailin advises global investors to consider regional security events and global economic activity independently. Multiple conflict zones and economic growth have generally co-existed for much of history. Less than 10 per cent of significant geopolitical shocks and conflicts have changed the direction of the world economy. Most have had very short-lasting impact on financial markets.

Bailin highlighted how security risks to world oil supplies represent a danger, and energy-security investments deserve a larger place in portfolios than otherwise. At the same time, the majority of the world’s petroleum supplies no longer rest in the hands of one cartel or country â€“ consequently, the possibility of an inflationary recession, as seen during the OPEC embargo of 1973/1974, is notably less, he added. See more commentary here on the impact of the Iranian air strikes. 

Market Update: US Inflation Scare
The US consumer price index (CPI) rose for a third consecutive month in March, exceeding expectations and stoking inflation fears. The US Federal Reserve says it needs to be confident that its preferred measure of inflation is, at last, on its way back to a 2 per cent. This means that a rate cut before July is unlikely, Bailin said. 

Bailin thinks an “inflation scare” is creating opportunities in high grade intermediate bonds which he believes offer good value to investors in this current environment. Equity risk hedges – for suitable investors – also appear attractive and historically cheap, he said. 

Investing in economic development – generating capital appreciation and income – is still the paramount opportunity for wealth preservation and growth. The precise number of rate cuts in the remaining eight months of 2024 is trivial by comparison, Bailin added.