What investors need to know about the Israeli and Iranian conflict
Little margin of safety in a world of rising risks.
Mentioned: Exxon Mobil Corp (XOM), Devon Energy Corp (DVN), Occidental Petroleum Corp (OXY), Lockheed Martin Corp (LMT), Northrop Grumman Corp (NOC)
Following Israel’s attack on Iran’s nuclear sites, the Morningstar US Market Index is down only 0.7% as of midday. It appears that investors are assuming this conflict will be similar to the outcome following military conflict in 2024. At that time, the conflict faded following several de-escalatory strikes on one another as opposed to leading to broader contagion within the region or oil markets. Essentially, the markets are taking the attitude of, “I’ve seen this movie before and know how it ends.”
Currently, the US stock market is only trading at a 2% discount to a composite of our long-term valuations. To put this in context, since 2010, the US market has only traded at this little of a discount (or premium) less than half the time. As long-term investors, we try not to be overly reactionary to short-term events but instead look to analyze how catalysts may or may not impact our longer-term assumptions and subsequent impact to our valuations. Considering there is such a small margin of safety below our valuations, we are a little surprised the market has not sold off more.
It may be our own recency bias, but these attacks have a different feel than last October and may last longer as Prime Minister Benjamin Netanyahu has stated that, “This operation will continue for as many days as it takes to remove this threat.” According to Damien Conover, Morningstar director of North America equity research, “These strikes appear to be more aggressive than last October.” Yet, Conover also notes that the recent strikes did not destroy oil-producing assets, which would be most economically damaging to Iran. By focusing the strikes on nuclear facilities, Israel may be attempting to lead Iran to respond with a less severe retaliatory response than if Israel had gone after oil-producing assets.
The most immediate significant risk to the US economy and markets is how much will oil prices rise and how long will they stay there. Oil prices initially rose as high as $77 from $69, but have since settled to $72. In context, oil prices averaged $76 over the course of 2024. According to Morningstar research director Allen Good, “We expect, absent a wider war, today’s rise in prices will likely prove to be a sell-the-news event. Oil markets remain amply supplied with OPEC set on increasing production and demand soft. US production growth has been slowing, but could rebound in the face of sustained higher prices.”
The immediate risk that would lead to higher oil prices would be if the conflict were to spread to include other state or nonstate parties, or if attacks were to expand to include oil-producing fields or infrastructure. US Secretary of State Marco Rubio was quick to distance the US from these attacks by announcing that this was a unilateral action by Israel and that the US was not involved.
Following today’s shallow selloff, the longer-term impact on the US stock market will be dictated largely by any changes to investors’ perceptions and projections the conflict could have on oil prices, the US economy, and ultimately earnings. These forecasts will in turn be based on response, subsequent counter-responses and whether or not additional parties, including the US, become involved.
Impact of rising oil prices
The more oil prices rise and the longer they stay there, the more inflationary the impact in the US and globally. Over time, high and rising oil prices would ripple through the US economy as consumers would have less discretionary spending capacity. This, in turn, heightens the risk that the US economy could slip into a recession, especially considering we expected the rate of economic growth in the US would slow sequentially over the course of this year even before this conflict began.
From a corporate perspective, near-term earnings expectations would be under pressure from a combination of slower top-line growth and compressed margins from higher energy costs. Those companies most exposed to consumer spending on discretionary items and those with highest energy-input costs would see the greatest deterioration.
Market reaction
The longer the conflict lasts, the higher the probability the market would rotate into a typical risk-off rotation. A risk-off environment is one in which investors have become increasingly cautious and shift their money away from investments perceived to be riskier and into those that are considered safer. In this scenario, growth stocks (which are currently trading at an 11% premium to our fair values) would fall further and faster than value stocks (which currently trade at a 14% discount to our fair values).
By sector, cyclicals such as consumer cyclicals, industrials, financials, and technology would likely be the hardest hit. Within those broader sectors, companies tied to discretionary spending and international travel and shipping would be disproportionately negatively impacted. Also, those companies that have high energy-input requirements would suffer. In the financial sector, a recessionary environment would lead to slower lending growth, wider corporate credit spreads, and an increase in default rates. In the technology sector, those that produce consumer goods would be most at risk.
A risk-off environment leads to a rotation into sectors with defensive characteristics such as consumer defensive, healthcare, and utilities. Interest rate-sensitive sectors such as real estate should also do well, as a flight to safety of US Treasury bonds would lead to a decrease in long-term interest rates. Defense stocks such as 4-star-rated Lockheed Martin LMT and Northrop Grumman NOC do well in a knee-jerk reaction to armed conflict.
However, unlike a risk-off trade from typical recessionary fears, armed conflict in the Middle East sends oil prices higher on fears that hostilities will lead to supply disruptions. According to our valuations, we had already thought the energy sector was undervalued and that energy provides a good, natural hedge in portfolios for both heightened geopolitical risks or if inflation were to rebound. Our pick among the global oil producers is 4-star-rated Exxon XOM. Conflict in the Middle East also leads to an improvement in sentiment for those oil producers located in the US and Canada, such as 4-star-rated Devon Energy DVN and Occidental Petroleum OXY.
What should investors do?
Don’t panic. Evaluate.
Based on your long-term investment horizon, goals and risk tolerance maintain your targeted allocations. However, this is good time to look for where your allocations may have become overstretched in areas that have become overvalued and reduce exposure in order to reallocate to other areas that are undervalued, especially those with defensive characteristics.
Scour your portfolio to sell any overvalued stocks that are rated 1 or 2 stars and evaluate where to reinvest proceeds into undervalued areas or stocks.
