Institute Alert

• Geopolitics are set to grab markets’ focus in mid-April. On April 13, Iran launched against Israel a large-scale attack of over 300 attack drones and roughly 100 cruise and ballistic missiles in three waves.
• The initial negative reaction across commodity and equity markets quickly turned mostly benign, but our view is that this latest escalation poses greater risks for potential future capital-market volatility.

• We reiterate our preference for quality in portfolio allocation and give specific investment guidance.

Geopolitics are set to grab markets’ focus in mid-April. On April 13, Iran launched against Israel a large-scale attack of over 300 attack drones and roughly 100 cruise and ballistic missiles in three waves, according to U.S. and Israeli defense officials.¹ Partly because of the long distance the weapons traveled (over 1200 miles), the attack took several hours to develop, and Israel, the U.S., the U.K., and Jordan intercepted and destroyed many of the weapons outside of Israeli airspace.² Israeli officials reported destroying nearly all the drones and missiles, with few serious injuries and only minor damage to military facilities.³ The attack was coordinated with rockets and ballistic missiles fired by Iranian-affiliated groups in Lebanon and Yemen.⁴ And on April 12, the Iranian military seized a container ship owned by an Israeli company and diverted the ship into Iranian waters.⁵

Iran said the attacks were in retaliation for an April 1 air strike on an Iranian diplomatic compound in Damascus that killed 13 people, including seven Iranian military officers.⁶ The Iranian general who was coordinating between Iran and proxy forces in Syria was among the dead, and this loss to Iran may have been the most significant since a U.S. airstrike killed an Iranian general in January 2020.⁷

The immediate market reaction was consistent with relief that Saturday night’s outcome was not worse. Middle Eastern equity markets opened lower on April 14 but quickly recovered losses. Asian and European equity markets were mixed on April 15, while Brent and U.S. West Texas Intermediate crude oil futures prices were flat, and the price of gold stayed below its pre-attack April 12 level. Iran widely communicated its promise of an attack after the April 1 strike on its Syrian compound, and that clear message gave markets a chance to price in risk before April 12.⁸ To illustrate, Brent crude oil spot price rose 7.3% between March 28 and April 5.

In our view, Iran’s advance warning appears to have given Israel time to prepare defenses. In addition, Iran’s concentration of missiles from the east and in the direction of military targets probably made it easier to intercept the attack. On that point, the U.S. and U.K. did much of the blocking, and we believe that such assistance may give the U.S. and U.K. some diplomatic leverage in helping discourage both countries from further direct attacks.⁹

However, looking ahead, our view is that diplomatic leverage may matter less than several potential risks for sudden escalation, with accompanying market volatility. One key risk is that, until now, the Islamic Republic of Iran had never launched an attack from its own soil against Israel.¹⁰ Now, either side may add direct attacks to its strategy. On April 14, Israel’s war cabinet announced plans for both offensive and defensive measures against Iran.¹¹ Second, and relatedly, Iran’s latest attack may have been probing Israel’s four-level aerial defense system’s response, as the Russians have done in Ukraine.¹² Iran may at some point attempt a more complex, multi-directional attack to confuse or overwhelm that system.¹³

Third and finally, capital markets likely also will consider that Iran may go beyond aerial attacks if Tehran decides that an ally of Israel goes too far. Earlier last week, Iran threatened the United Arab Emirates with closing the Strait of Hormuz because of the former’s economic cooperation with Israel.¹⁴ Iran’s April 12 hijacking of the container ship is not a new tactic, but we view it as a possible reminder that Iran stands ready to disrupt traffic through the Strait, which conducts about 20% of the world’s oil supply.¹⁵

Essentially, with direct attacks now in play, further escalation could magnify the risk that someone’s future miscalculation may, in turn, also magnify the negative humanitarian and market impact. We reiterate our preference for a quality focus in portfolio allocation and favor considering the following steps:

1. Rebalance: After five straight months of gains in the S&P 500 Index, the portfolio’s balance between stocks and bonds may have increased equity risk by more than originally desired. Now is a good time for a conversation with an investment professional about rebalancing risk to target levels. A good place to start trimming is in the Information Technology and Communications Services sectors, which look expensive from a price-to-earnings perspective. Long-term investors may prefer to reallocate to short-term fixed income. Investors with more of an interest in tactical allocation could consider rebalancing from technology-related funds or positions into our favored sectors: Industrials, Materials, Energy, and Health Care.
2. Prepare for likely volatility in fixed-income markets: An unexpected event may have a larger market impact, which may temporarily delay the resumption of disinflation. We prefer short-term fixed income instead of holding cash and prefer investment-grade intermediate- and long-term bond positions close to long-term target allocations. We favor making sure that the portfolio is not underweight to strategic targets in intermediate-term fixed income.
3. Consider commodities to help diversify: We favor a commodity allocation for long-term investors, including a small allocation for income-oriented investors. For tactically oriented investors, an overweight to commodities could be a good way to hedge further geopolitical risk.

¹ Institute for the Study of War, “Iran Update”, April 13, 2024; and U.K. Telegraph, “Iran’s attack on Israel has thrown down the gauntlet to the West”, April 14, 2024.

² An Israeli military spokesman claimed that 99% of the weapons were shot down by fighter jets and warships from Israel and these other countries. . Bloomberg News, April 14, 2024.

³ Bloomberg News, April 14, 2024.

⁴ The Washington Institute, “The Middle East’s Perilous Moment”, April 14, 2024; and U.K. Telegraph, “Suspected Yemeni drone downed over Israel, IDF says”, April 14, 2024.

⁵ U.K. Telegraph, “Iranian troops hijack Israeli-linked ship in helicopter attack”, April 13, 2024.

⁶ Washington Post, “Why Did Iran Attack Israel?”, April 14, 2024.

⁷ Bloomberg News, April 13, 2024. Israel has not claimed responsibility for the strike on the Damascus compound.

⁸ U.K. Telegraph, “Israel draws up plans to attack Iran in response to drone strike”, April 14, 2024.

⁹ Both Israel and Iran face internal political strains, although they appear greater in Iran. And both face violence coming across their borders, which seems to be a more serious issue for Israel. For more, please see U.K. Telegraph, “Iran’s attack on Israel has thrown down the gauntlet to the West”, April 14, 2024; and BBC, “Pakistan-Iran Strikes: Where is Balochistan and why is it being targeted?”, January 19, 2024.

¹⁰ Institute for the Study of War, “Iran Update”, April 13, 2024.

¹¹ Multiple news sources reported that the Israeli war cabinet is considering a military response to Iran’s attacks. See Bloomberg News, “Oil Traders Weigh Risks of Iran-Israel Conflict in Tight Markets”, April 14, 2024; The New York Times, “Israel weighs response after Iranian Attack”, April 14, 2024; and U.K. Telegraph, “Israel draws up plans to attack Iran in response to drone strike”, April 14, 2024.

¹² For more on Israel’s four-level aerial defense system, please see IHS Jane’s, “Israel-Gaza: Situation update, 2 April 2024”.

¹³ In 2018, Iranian missiles landed in Israel from the Golan Heights in Syria, and Iranian ally, Hezbollah, could launch missiles at Israel from the north.

¹⁴ Reuters, “Iran says it can close Hormuz Strait, views Israeli presence in UAE as threat”, April 9, 2024.

¹⁵ U.S. Energy Information Administration, “The Strait of Hormuz is the world’s most important oil transit chokepoint”, November 21, 2023.

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