What to make of the US-Iran escalation…

Montreal, January, 23, 2020

One of our objectives in 2020 is to engage more frequently with our stakeholders when an event that is perceived to have a significant impact on global capital markets takes place. It is our view that such an event took place when the United States struck Iran by eliminating Qaseem Soleimani on January 2nd.

It may be worth taking a step back and discuss the importance of Soleimani, whom the western media outfits may not have adequately described. For decades, General Soleimani was responsible for implementing Iran’s foreign policy. According to US officials, he masterminded the country’s backing of Hezbollah in Lebanon, propped up and provided the fighting forces for Bashar al-Assad during the brutal Syrian civil war and developed the Shiite militias in Iraq. As head of the Islamic Revolutionary Guards Corps Quds Force, Soleimani established networks all over the region. Importantly, Soleimani is also responsible for repelling ISIS from Iraq after the US withdrew in 2013. To sum it up, he was an important character.

As such, our initial reaction was that markets were unnaturally calm, even more so than after Iran’s proxies attacked the petrochemical facilities in Saudi Arabia last September. A small drop in the first day, a recovery on the next. Basically, markets shrugged what could have been an important catalyst.

Some argue that the timing of the event, while President is under a formal impeachment inquiry, is an attempt to divert attention but experts argue that this action must have received presidential sanctions awhile back, certainly before the impeachment process was initiated. This was intended to be a deliberate signal in response to Iran’s attacks of the US and its allies via proxies since last summer. Iran is accused of hitting Saudi oilfields. A US drone before that. Oil tankers in the Persian Gulf before that. And this week they directed attacks at the US Embassy in Baghdad.

The good news is that Trump drew the line by signalling what Iran must do to avoid retaliation, hinting that it was ready to strike over 50 Iranian sites.

The next day, Iran signalled that it was rolling back its commitment to the multilateral nuclear deal.

At first sight, one could argue that this was an alarming development as it implicitly means that Iran could restart their military grade uranium enrichment program. But on second thought, this is perhaps the smartest response from Iran. Here’s why. After all, Trump’s United States already pulled out of the deal. In fact, this is what triggered the initial escalation. So while it may make a major media headline, pulling out does not cause direct harm to the United States. It is unlikely that the United States retaliates for that.

The Iranian regime is used to all this. It has been under an embargo for multiple decades. Our guess is that unless there is a ‘rogue agent’ amongst their ranks, they will be very careful not to strike American interests in the region. That said, nothing prevents them from continuing to attack assets of United States allies in the region, including Israel and Saudi Arabia, or try to influence the Iraqi government to force the full withdrawal of American troops.

What to make of all this?

Well, judging from the initial reaction, the market does not think that war with Iran is probable. I do not disagree. If Trump wanted war with Iran, he’s had numerous opportunities to justify a military action it since last summer (see above). Also keep in mind that we know, in retrospect, that the Trump Administration tried to set up a meeting with the Talibans at Camp David. Instead, Trump only responded with a military action after the United States embassy in Baghdad was hit. The Iranians may have underestimated his resolve, but now they get it. They understand where the line has been drawn. Case in point, shortly after, Iran launched two dozen ballistic missiles against allied operated air fields in Iraq, causing minimal physical damages, and no casualties. This was an intentional miss. As such, and notwithstanding the fact that the United States is entering in an election year, we don’t think that the prospect of a war with a Middle East nation with nuclear capabilities is likelier than it was a week before. The markets seem to have priced the risk accordingly through their inaction. Similarly, we don’t see this geopolitical development as cause to adjust meaningfully portfolios allocations.

So, to the extent that we don’t think a military escalation between the United States and Iran is probable, what are the biggest risks that may not be appreciated adequately? We have three in mind.

Firstly, we think a big risk this year is what might come after the United States presidential elections in November. We are concerned about what could happen to the greenback and to the interest rates should a constitutional crisis erupt if the party who loses refuses defeat.

Secondarily, we are concerned about the emergence of a rift of the internet into two blocks in what could turn into a new Cold War opposing the US and China for the control of the technology that will harness 5G and future developments. If de-globalization and protectionism occur in the technology space, it could stress, if not break supply chains in ways that could awake the spectre inflation.

Thirdly, we are worried about the impact of a Federal Reserve policy mistake. In effect, the Federal Reserve’s balance sheet has started to grow again in September of last year after having been progressively reduced in the prior twelve months. To be specific, for the first time in a decade, the Federal Reserve injected cash into the short-term money market in response to a repo market seizure. The repo market matches up banks that would need short-term cash with other banks with cash to loan out in the short term to earn interest. It was supposed to be a temporary operation, driven by an unusual confluence of tax and technical considerations. However, four months after the initial intervention, the Federal Reserve has continued to provide liquidity to depository institutions and had not reverse course. It appears that the renewed ability of banks to refinance their operations by pledging their assets to the Federal Reserve may have triggered the buoyant mood we’ve seen in risky assets globally. The question is as capital markets appear addicted to permanent quantitative easing in one shape or form, what happens if the Federal Reserve underestimates the impact of its own action and that a significant selloff in risky assets occurs following a policy reversal given how precarious liquidity conditions are?

Dimitri Douaire, M. Sc., CFA
Co-Chief Investment Officer

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