January 9, 2020
Paul Christopher, CFA, Head of Global Market Strategy
Darrell L. Cronk, CFA, President of Wells Fargo Investment Institute
Iran Strikes Back
- Iran launched short-range ballistic missiles at U.S. bases in Iraq earlier this week, claiming the attack in retaliation, after the U.S. killed a highly influential Iranian general last week. S&P 500 Index futures initially responded negatively, and gold and oil prices rose.
- Yet, these moves reversed their losses; the S&P 500 moved to a new high, and geopolitical risk premiums are being repriced lower, as both sides publicly indicated a desire to de-escalate and avoid a future war.
What it may mean for investors
- However, we believe a high degree of tension will remain between U.S. and Iran, and we once more reiterate the investment guidance in our 2020 Outlook.
Iran launched short-range ballistic missiles at U.S. bases in Iraq earlier this week, claiming the attack in retaliation for the U.S. killing of a highly influential Iranian general last week. S&P 500 futures initially responded negatively, and gold and oil prices rose. Yet, these moves reversed course, and the S&P 500 moved to a new high as both sides publicly pledged to de-escalate.
Some Iranian retaliation was expected, especially against U.S. interests in the region. And we believe Iran’s reprisal accomplished two objectives. First, Tehran signaled that it can strike easily and at low cost. Iran’s various weapons target a wide radius in the Middle East.1 Second, by launching the missiles from inside its territory, Iran broke with its past practice of using proxy militias based elsewhere to cloak itself in deniability. By claiming full responsibility, we believe Iran messaged that it was matching last week’s U.S. escalation.
We view both sides, especially Iran, as having a strong incentive to avoid a full-scale war. After the missile strike, both countries’ leaders publicly affirmed that they want to avoid a war. Moreover, current U.S. sanctions tighten Tehran’s financial resources, limit foreign policies, and contribute to domestic unrest. Most recently, for example, Iran used violence to suppress November riots by Iranian protestors over gasoline prices.2
We believe a high degree of tension likely will remain between the U.S. and Iran. In his January 8 public statement, President Trump threatened new Iranian sanctions, which we believe should add to Iran’s economic pain. Also, cyber attacks against each other could be another low-cost way for the two countries to maintain the conflict.3
We believe Iran now has an even stronger incentive to use its political influence in Iraq and its Iraqi militia network to expel U.S. forces based there, and thereby, to move U.S. forces further from Iran. On January 5, Iraq’s Parliament approved a non-binding resolution to eject U.S. troops. Iran does not dominate Iraq’s Parliament but can influence it through the chamber’s Shiite members. For example, almost no Kurdish and Sunni lawmakers participated in the January 5 vote, and Iraqi public demonstrations against Iranian influence are common. Still, for decades Iran has built strong regional influence through the forceful push from militias that Iran trains, finances, and manages, especially in Iraq. Iran-backed Iraqi militias escalated their targeting of U.S. troops throughout December. In turn, these triggered U.S. reprisals around year-end, including the targeting of the Iranian general.4
Both countries are still vulnerable. U.S. interests around the region (especially troops) are within range of various Iranian weapons, while new U.S. sanctions could weaken Iran’s already frail economy. Still, the U.S. and Iran say they want to de-escalate, and investors appear to be repricing geopolitical risk premiums lower. Looking forward, we see three potential scenarios:
Tensions remain high, but no further escalation from current levels (our base case)—positive for risk appetite: We expect decreasing fears of inexorable escalation toward all-out war. The countries’ vulnerabilities likely imply a high degree of ongoing tension. The two sides are likely to revert to low-cost, low-profile measures (e.g., cyber, drone and rocket attacks) in our opinion.
Continued escalation short of all-out war (possible but not probable, in our view)—negative for risk appetite: If one country intensifies its attacks on the other’s weakness, the other could retaliate with a further escalation. We believe both sides understand this risk, but political calculations are not always accurate.
All-out war (very unlikely, in our view)—strongly negative for risk appetite: We have no illusions that wanting de-escalation necessarily leads there, particularly if each side presses the other’s weakness. However, we believe all-out war would bring very high political costs to leaders in both countries, especially to Iran’s ruling establishment, which already faces significant challenges in its foreign policies and popular unrest.
So far, market reactions seem cautiously oriented toward the stabilization scenario. Regarding specific markets, we believe the U.S.-Iran escalations of this past week justify the geopolitical risk premium embedded in our 2020 oil and gold targets, while not substantially altering the supply/demand outlook. We also continue to expect U.S. dollar depreciation to support global risk markets, but new U.S.-Iran escalations could strengthen bids for perceived risk havens and could endanger that outlook.
Tensions remain high, and future events may change political calculations in ways that suddenly and unpredictably may reverse the markets’ economic and risk outlook. We do not advocate jumping to conclusions about a U.S.-Iran war. However, we again recommend our 2020 Outlook, whose theme is about resilience—specifically, what it may take for the global economy and markets to remain resilient amid geopolitical risk, and how investors can be diligent when low interest rates encourage calm but may underestimate economic and political risks.5
1 Nasser Karimi and Jon Gambrell, “Iran calls missile attack on Syria militants a wider warning”, Washington Post, June 19, 2017.
2 The New York Times, “Iran Says Protests Are Over, But Evidence Suggests Otherwise”, November 21, 2019.
3 Forbes, “Secret Iranian Network Behind ‘Aggressive’ U.S. Cyberattacks Exposed In New Report”, November 19, 2019.
4 The New York Times, “Iran-Backed Iraqi Militia Vows Revenge to U.S. Strikes”, December 30, 2019.
5 For more details, please see our report entitled, “Outlook 2020: A Call for Resilience”.
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