Analysis-Middle East escalation tilts balance of risks in markets

An RAF Typhoon aircraft takes off to join the U.S.-led coalition from RAF Akrotiri to conduct air strikes against military targets in Yemen, aimed at the Iran-backed Houthi militia that has been targeting international shipping in the Red Sea, in Cyprus, in this handout picture released on January 12, 2024. UK MOD/Handout via REUTERS/File Photo

By Rae Wee and Ankur Banerjee

(Reuters) – For global investors who came into 2024 with doubts about how long stock markets can rally and when central banks will cut rates, a sudden widening of the war in Gaza is swaying the narrative and could prompt them to cut exposure to risk.

Market reactions were initially restrained on Friday to news that the United States and Britain had launched strikes against Houthi military targets in Yemen in response to the movement’s attacks on ships in the Red Sea.

However, oil climbed [MKTS/GLOB] while U.S. Treasuries and stock markets tensed after the strikes.

Investors will be seeking to reduce exposure to riskier markets and adding to safe havens as they wait to see how the Middle East situation develops, particularly the disruption to oil supplies and trade, analysts said.

“Markets are on edge as risks of an escalation have risen,” said Charu Chanana, head of currency strategy at Saxo in Singapore.

“It will be particularly important to watch any further actions from either side especially going into the long weekend for the U.S., and particularly the threat of a wider regional conflict. With near-term focus on geopolitical escalation risks, yen and gold could see safe-haven buying.”

The odds are high. The strikes by the United States and Britain are the first on Yemeni territory since 2016, taking tensions several notches higher in the Israel-Hamas war raging since October.

The Iran-aligned Houthis, who control much of Yemen, have been attacking ships passing through the Red Sea for weeks in what they say is a response to Israel’s war in Gaza.

Although Washington said there was no intent to escalate tensions, the Houthis have vowed to retaliate to any attack.

In December, an Iranian Revolutionary Guards commander said the Mediterranean Sea could be closed if the United States and its allies continued to commit “crimes” in Gaza.

ANZ’s head of research for Asia, Khoon Goh, said freight rates had already risen over the past few weeks due to the shipping disruptions.

“If this strike is able to resolve the issue and shipping lanes can be secured again and things normalise, then that’ll be positive as we’ll see a normalisation of freight rates,” he said.

“The concern is that if this starts to escalate…which will cause a potential spike up in oil price in particular, and further disruptions in shipping lanes.”

DIVERSIONS

Weeks of disruptions in the Suez Canal, which handles about 12% of worldwide trade, have already hurt businesses.

Global trade declined by 1.3% from November to December 2023 as militant attacks led to a plunge in the volumes of cargo transported in the Red Sea region, German economic institute IfW Kiel said on Thursday.

Shipping giants such as Maersk and Hapag-Lloyd have been sending their vessels on longer, more expensive journeys around South Africa’s Cape of Good Hope. German logistics giant DHL Group has advised customers to manage inventories differently.

How far fuel and shipping costs rise plays more immediately into market expectations of a stock market rally, which are based on the view the U.S. economy will avoid recession and the Federal Reserve, European Central Bank and other global banks will cut rates this year.

“There will be a shift back towards risk aversion. This hasn’t fully blossomed out into a proper risk-off mode,” said Rob Carnell, head of Asia-Pacific research at ING of the air strikes.

“I think people are looking for a little bit of safety at the moment. So I think the bond market’s probably the clearest indication of where things are going.”

Oil prices indicated by Brent futures are up 9% since mid-December, and jumped 2.0% to $79.00 a barrel on Friday. Gold was more muted, as were bond yields.

Ten-year Treasury yields barely budged, staying just under 4%. Expectations of rate cuts have driven their yields down a full percentage point in about two months.

“A significant escalation is likely to have notable market impact,” said Josh Crabb, head of Asia-Pacific equities at Robeco in Hong Kong, but “the probabilities are hopefully low.”

(Reporting by Rae Wee and Ankur Banerjee; Writing by Vidya Ranganathan; Editing by Raju Gopalakrishnan)