House View by the Chief Investment Office
Global risk radar: Geopolitics in the Middle East
Possibility of oil supply shock?
Saudi Arabia and Iran have been competing for influence in the Gulf region and fighting through proxy wars for years. Tensions between these two states are not new, but they have intensified as of late. Although the risk of direct Saudi-Iran confrontation is very low, in our view, further escalation cannot be ruled out.
Middle East escalation – base scenario: We do not expect meaningful sanctions to be raised against Iranian energy exports, or the long-running tensions between Sunni Saudi Arabia and Shiite Iran to escalate to a direct armed conflict. Other geopolitical risks in the region, such as ISIS attacks aimed at disrupting oil production, shouldn't lead to a large or sustained spike in the oil price. That being said, the oil market could still price in a geopolitical risk premium if tensions in the region rose.
Middle risk escalation – risk scenario: Deeply rooted tensions between Iran and Saudi Arabia could intensify through proxy wars in the MENA region, possibly disrupting energy exports out of the Middle East. If this coincided with renewed sanctions on Iranian energy exports, the oil price could reach USD 80/bbl and stay there for three to six months. CIO attaches a very low probability (less than 10%) to this risk scenario.
Risk scenario implications
If escalating tensions in the Middle East and North Africa were to disrupt energy exports, the oil price would spike and likely cause a correction in risky assets. Under such a scenario, we would expect lower global growth and higher inflation relative to our base case.
If the oil price spikes to USD 80/bbl, our economists expect global growth to decelerate by around 0.25–0.5% over a 12-month horizon, relative to our base case forecast. Global inflation could exceed our base case estimate by around one percentage point. Net oil importers, such as the Eurozone, are expected to fare worse under this risk scenario.
On the other hand, net oil exporters, such as Russia, Brazil and Venezuela, would benefit from rising oil prices, and their appreciating currencies would limit the inflationary impact, too. In the US, a higher oil price would stimulate investments in the shale oil sector, thereby reducing the negative impact on growth. Graph below shows how different regions rely on imported energy.
Crude oil production and consumption by region
In million tons per year, for 2016
Source : Enerdata, "Global Energy Statistical Yearbook 2017" , as of 10 July 2017
We would expect the Federal Reserve to look through the spike in headline inflation and refrain from hiking rates faster. The impact on the Fed's preferred measure of inflation – core PCE (personal consumption expenditures) inflation – would be small and temporary. We believe the ECB would remain in a wait-and-see mode and possibly extend its quantitative easing (QE) program by six months.
Investors who wish to protect their portfolio against this risk scenario can consider investing in:
Crude oil and oil products: Direct long exposure to the commodity would help investors hedge against an escalation in the Middle East. This position should deliver a positive performance even under our base case, as we expect larger oil inventory drawdowns in the months to come and seasonally improving oil demand.
Energy companies: The energy sector would benefit from higher oil prices under this risk scenario. Even under our base case, we expect the sector to be supported by improving earnings on the back of cost-cutting measures and gradually rising oil prices.
Gold: The yellow metal is a safe-haven asset that is expected to appreciate under heightened geopolitical risk. During an oil supply shock, it also benefits from rising inflation expectations.
Safe-haven currencies: The Swiss franc and the Japanese yen should appreciate as investors seek protection in traditional safehaven assets when geopolitical risks rise.