Wall Street Is Gaming Out All the Possible U.S.-Iran Scenarios

(Bloomberg) -- Investors and analysts returning to work this week after the festive break found an unwanted item on their desks: a geopolitical puzzle with a bevy of players, complex rules and no clear solution. They’ve spent every minute since trying to figure it out.

As the market turmoil sparked by the U.S. killing of an Iranian military leader eases, Wall Street is mapping out scenarios that range from retaliation by Tehran through proxies to tit-for-tat escalations.

The threat appeared to intensify Tuesday after Iran said it is evaluating 13 possible ways to inflict a “historic nightmare” on America, while dozens were killed in a stampede at the general’s funeral.

“The market is underestimating the risk,” said Fabrizio Fiorini, the chief investment officer at Pramerica Sgr Spa in Milan. “Investors are forgetting that equity is discounting a perfect alignment of planets in terms of monetary and fiscal stimulus and economic rebound and political stability. What happened in Iraq is suggesting that the planets are not aligned.”

Here’s a look at some of the scenarios money managers and strategists are considering, in their own words:

BlackRock

Base case: Iranian retaliation is likely; energy infrastructure in the region is particularly vulnerable.

Status quo: We prefer U.S. Treasuries to lower-yielding peers as portfolio ballast and like inflation-protected securities against inflation risks.

Escalation: We believe markets are underestimating political risks, especially in the Gulf, North Korea and in cyberspace.

Morgan Stanley Wealth Management

Base case: Tensions are high and risk is elevated, but Iran and the U.S. have constraints that likely limit escalation.

Status quo: Possible near-term Iranian retaliation includes attacks against Israel using Hezbollah, proxy escalations in northern Iraq and cyberattacks. Iran could pursue a more aggressive strategy, but the regime remains mindful of U.S. military power. Meanwhile, election-year politics likely limit U.S. engagement.

Escalation: The primary threat to oil prices is an Iranian escalation that draws catastrophic U.S. reprisal. Middle East military escalation historically meant higher oil prices, but as we wrote in The New Economics of Oil, even a major escalation would likely drive prices for only a short time.

Nomura International

Base case: The more likely scenario involves a retaliation from Iran, but not enough to spark an outright war with the U.S.

Status quo: Even if we assign relatively a high probability (of around 80%) to the scenario of no severe escalation and maintain our view that the positive themes of U.S.-China trade, improving global data and a bottoming of the semiconductor down-cycle continue, the risk-reward of holding our current level of positive Asia risk has fallen from what it was a few weeks ago. Thus, we reduce some of our outright short USD/Asia FX positions.

Escalation: The risk that the situation in the Middle East could intensify is undeniable and, if this occurs, it could lead to a further rise in crude oil prices and risk reduction. The sensitivity of major currencies to crude oil prices and global stock prices since October 2019 indicates that JPY appreciation is likely to become evident when crude oil prices rise during risk-off periods. Thus, in the short term, JPY long positions are effective as a hedge against the worsening situation in the Middle East.

Rabobank

Base case: A nervous waiting game is likely to continue as investors brace themselves for Iran’s retaliation. It is worth noting that gold is trading only modestly below the recent high and USD/JPY is struggling to gain a better upside traction following its recent fall.

Status quo: An indication that geopolitical risk remains elevated is Brent crude holding well above the pre-Iran crisis level. The sharp spike in oil does not bode well for energy importers. In the CEEMEA space Turkey and South Africa are particularly vulnerable as domestic factors are a major source of risk as well.

Escalation: Geopolitical tensions may escalate substantially in the coming days as Iran is reportedly assessing 13 scenarios to revenge the killing of Qassem Soleimani.

TD Securities

Base case: The reality is nobody can say with any confidence how the U.S.-Iran tensions will evolve. As such, the TD securities team would be keeping an open mind to changing the crude oil view should tensions escalate into 2020.

Status quo: For now, the recent oil spike is being faded as we take at face value Iran’s “promise” to stick to military targets and keep any retaliation proportional.

Escalation: The risk of increasing geopolitical tensions and a potential negative supply shock originating from the oil market could well mean that gold can move north of $1,600 should tensions escalate further, which also would help to send the rest of the precious metals complex to new multi-year highs.

--With assistance from Yakob Peterseil, Cecile Gutscher and Anchalee Worrachate.

To contact the reporter on this story: Sam Potter in London at spotter33@bloomberg.net

To contact the editors responsible for this story: Sam Potter at spotter33@bloomberg.net, Sid Verma, Yakob Peterseil

©2020 Bloomberg L.P.