Quick Thoughts: Middle East conflict—few implications (for now) for markets

We at the Franklin Templeton Institute and the firm acknowledge the humanitarian crisis unfolding in the region. These are sad and challenging times, when it is not easy to detach and draw implications for the global economy and markets. That said, it is our responsibility to focus on those implications and what it means for investors.

We do not see wider economic or market impacts stemming from the conflict in its current form. Unlike Russia’s invasion of Ukraine, with its significant direct and indirect impacts on global supplies of energy, fertilizer and food stuffs, the war between Israel and Hamas—assuming it does not spread into a wider regional conflict—will likely cause few, if any, significant disruptions to global supply of critical goods. Even its impacts on Israel’s vibrant technology and pharmaceutical sectors are likely to be modest, with few adverse impacts on those industries at a global scale.

For example, Israel’s computer chip production accounts for only about 1% of total global industry output.¹ To be sure, some loss of production may result from labor shortages, as some 300,000 reservists are called up across Israel (and from abroad). Hence, it is difficult to believe that some level of disruption to production can be avoided, in those sectors or elsewhere in Israel’s economy.

At times like these, energy supply and price shocks are never far from investors’ minds. Memories remain of the experiences during the 1970s. During the 1973 Arab Israeli war and again in 1979 following the Iranian revolution, embargoes and other dislocations disrupted oil supplies from the Middle East. In the event the current conflict was to escalate beyond its present scope, oil prices could spike and, potentially, supplies could be disrupted.

But in contrast to the episodes from 50 years ago, regional politics and alliances have changed. Relations between Israel and the United Arab Emirates (UAE) have improved in recent years. This year, expectations were emerging of a similar thawing of relations between Israel and Saudi Arabia. Even if formal ties have been postponed by the current conflict, the reality is that the Arab countries of the Persian Gulf are less likely to move against Israel and the United States and use oil production and distribution as a weapon.

Indeed, the muted response thus far of major regional actors such as Turkey, Egypt, Saudi Arabia, Qatar and the UAE to the war between Israel and Hamas attests to the different nature of regional politics and alliances. Sympathy for the plight of innocent civilians is surely one reason. But so, too, is the concern shared in many parts of the Middle East that war, conflict, and potential refugee crises are best avoided.

That is not to say that some actors may see benefit from conflict. Russia is keen to divert world attention from its invasion of Ukraine. It also hopes that the West may soon tire of waging wars, even by proxy, on multiple fronts. Any number of regional groups might wish to exploit the conflict for political gain. The region, understandably, remains fraught with uncertainty, and escalation can never be ruled out.

One possible way to imagine a widening of the conflict is via Iran, which has been a long-time supporter of Hamas. Were Iranian-backed militants in Lebanon (e.g., Hezbollah) or elsewhere to attack Israel, counter strikes from Israel could escalate the conflict into a regional war. Iran might then attempt to militarily disrupt or sabotage Persian Gulf oil production and shipments via the Straits of Hormuz. In such scenarios, oil prices would surely jump, as would market risk premiums.

It is therefore in the economic interests of Israel and its allies (the United States and Europe) to pursue its national security interests. At the same time, it is also in the interests of Israel and its allies to not unnecessarily escalate the conflict.

The United States has thus far managed to both provide unequivocal support for Israel and to urge restraint. The United States has warned potential adversaries not to exploit the situation. It is impossible to say with certainty, or even high conviction, that those messages will be heeded or that Israel will refrain from risky escalation in the event it is again attacked. But there is reassurance in the knowledge that the region’s powers are aware of the potential for missteps and are likely to avoid them.

The last thing we would highlight is the likelihood that this increase in the global geopolitical temperature will accelerate the trend towards regionalization of trade. Reshoring has been driven largely by a desire for each country to create strategic stability after the experiences around COVID and the Russia/Ukraine war.

In sum, as horrific as the images have been and continue to be, the risk of major disruptions to the world economy stemming from the Israel-Hamas conflict appear, at present, to be contained. While we and investors must remain vigilant regarding those risks, we do not believe that the conflict in its current form is likely to have significant impacts on global economic growth, inflation, corporate profits, interest rates or exchange rates.