Why you should fade the war hysteria

Oil prices have jumped over $6 a barrel since the Hamas attack on Israel as a geopolitical risk premium became embedded in the oil price. The surprise attack brought up memories of the Yom Kippur War 50 years ago, in which the armies of Egypt and Syria launched a simultaneous surprise attack on Yom Kippur in 1973 that left Israel fighting for its existence. In the wake of that war, the Arab-producing states launched an oil embargo on the West which devastated growth. It’s no wonder oil prices popped this time.


I think investors should fade market’s war fears. Here’s why.


SitRep: Not a repeat of 1973

Let’s begin with a sober evaluation of the military situation report, or SitRep. While the Hamas attack was a surprise and well-organized, it’s not a repeat of the Yom Kippur War of 1973. Then, two large conventional armies with (then) new weaponry in the form of Soviet-supplied Sagger anti-tank missiles under Surface-to-Air Missile (SAM) umbrellas, which largely negated the effects of Israeli air superiority, launched a devastating attack on Israeli forces. Then, Israel faced an existential crisis as its forces could have been driven into the sea.


Today, the Hamas-led attack overwhelmed surprised defenders and overran settlements bordering Gaza. Terrorism is the wrong word to describe the attack, a better word is barbarism, in the medieval manner of how Mongol hordes of Genghis Kahn sacked the cities they conquered and put the population to the sword. The events of 2023 can better be described as a 9/11 moment, which is an experience burned into the psyche of Israelis.


For some perspective on force structure, this UTV article describes Israel with “169,500 active military personnel in the army, navy and paramilitary”. Recent reports indicate that the government has mobilized 300,000 reservists. While the exact Hamas force strength is unclear, the article quotes a 2021 write-up in the Times of Israel that “quoted an unnamed senior Israeli commander as saying Hamas had an army of 30,000 men”. Israel has stated that it plans to invade Gaza to eliminate every vestige of Hamas. While not all Israeli forces will be deployed there, Israeli forces outnumber Hamas by roughly 15-to-1, plus it has the advantage of superior technology. That’s why this is not 1973.


This War on the Rocks podcast described the urban warfare challenges of the Israeli military response in entering Gaza. The battle for Mosul by U.S. and Coalition forces is a comparable example. That attack took months to plan and the operation took months to execute. Any Israeli incursion into Gaza is unlikely to be quick or antiseptic. Axios reported that former Israeli prime minister and now new member of the new Israeli unity government Benny Ganz “told Biden the effort to dismantle Hamas could take years”.


The Biden Administration has pressed the Israeli government to formulate a plan for its Gaza incursion. The objective shouldn’t just to be eradicate Hamas or the ability of Hamas to launch attacks into Israel, but what happens afterward. Hamas is the governing authority in Gaza, what happens afterward if its leadership has been eliminated? While Israel has stated that it doesn’t intend to re-occupy Gaza, the Israeli government hasn’t formulated an exit strategy for its forces. 


All very good questions. The current response as reported by Axios is “they aren’t there yet and for now are focused on the counteroffensive to the Oct. 7 attack by Hamas that ignited the war”. The eyes of the world are on Israel and its future relationships with her neighbours hinge on the answers.

For investors in U.S. equities, history shows that negative reactions from conflicts should be faded.



The market reaction

It is an unfortunate fact of life that markets are insensitive to human suffering. Instead, Mr. Market focuses on factors like growth and interest rates. While the tail-risk of another Arab Oil Embargo and subsequent recession is always present, the market has largely shrugged off geopolitical risk.


Take oil prices as an example. While the spot price has increased, the more relevant long-term price is the strip price used by oil producers to hedge production. For the uninitiated, the strip price for oil is based on a series of oil price contracts into the future. As an example, a 12-month strip is 1/12th of the front month future price, plus 1/12th of the next month futures price, and so on until all 12 months are summed.


Strip contrasts trade OTC, but investors can see an indicative price based on the futures contract, which can be illiquid past the front month. The chart of the 36-month strip oil price shows that it hasn’t even breached its recent high.



Similarly, these accompanying charts of the relative performance of energy equities and oil and gas industries show that none have rallied to new relative highs. I interpret this to mean that the market’s judgment of geopolitical risk is relatively low.



That’s because there are several firewalls to the supply disruptions of oil. First, the U.S. has turned a blind eye to the sale of Iranian crude to China. While that technically represents a sanctions violation, Iranian supply of oil to China represents a relief valve that Chinese demand doesn’t overwhelm global demand.


As well, the U.S. has concluded an agreement with Venezuela for a partial lifting of sanctions for a commitment for the Maduro government to adhere to fair and free elections next year. Venezuelan crude represents another source of global supply.


Remember that Saudi Arabia and Russia agreed to cut supply in order to boost the oil price? Should the unthinkable happen and the Straits of Hormuz is closed, Saudi Arabia has spare production capacity should hostilities break out.


Relax, fade the war fears.



Regional markets

The performance of regional markets is a different matter. Moody’s reported that Israel’s labour force is 4.5 million people. The government has mobilized 300,000 reserves and this an able-bodied demographic that is largely employed and in the labour force. The mobilization takes over 6% of the working population out of the workforce, which will be a drag on growth and strain government finances.


Using the battle for Mosul as a template, the battle for Gaza is likely to take months, and an exit strategy hasn’t been fully articulated by the government. It’s unclear how long the drag on growth will last.



It is therefore no surprise that MSCI Israel (in USD) has dropped dramatically. As many Israeli companies are listed on NASDAQ, a comparison with junior NASDAQ stocks (QQQJ) is appropriate, as well as MSCI All-Country World Index (ACWI). No matter how it’s measured, MSCI Israel has violated key relative support levels. Avoid, at least some clarity on a plan for reserve force demobilization. Axios reported that Israeli authorities expect the Gazan incursion to be a long-lasting affair:


There was one consistent message President Biden heard from nearly all the Israeli officials he met in Tel Aviv: The war in Gaza will take time — and will test Israel’s support from its allies, Israeli and U.S. officials say.