The conflict in Syria is very complex, given the country’s diverse ethnic mix and the influence of foreign powers. This implies a high risk of a further dramatic escalation of the conflict, with negative spillovers into the broader region. Short term, UBS notes that the response of the Assad regime to a potential military strike will be crucial, while a key question for the medium term will be whether state structures can be preserved in Syria, so that contagious chaos can be avoided. UBS sees the impact on the international economy comes mainly via risk appetite and oil prices. Should the conflict be contained, the global economic fallout should be limited. However, the worst-case scenario of a regional spread of hostilities, involving Iran, Israel or the GCC, would be a lot more damaging.
Via UBS' Stephane Deo,
There are essentially two channels by which the situation can impact markets: an increase in oil prices and a decline in risk appetite. We show that such a supply shock on oil prices would have a straightforward negative effect on risky assets, notably equities. The impact on yields is less obvious as inflation expectations would surge. On balance though, we think higher oil prices would create a FI rally only if they derail the nascent recovery. We also analyse market reactions in case of a surge in risk aversion. We find that the only place to “hide” is the US yield curve. We also provide historical analysis of the optimal portfolios for different risk regimes.
We do not think that Syria per se is large enough to have a meaningful and long-lasting impact on oil prices. However, more widespread turmoil in the region, or simply markets pricing in a greater geopolitical risk premium, could definitely have an impact on oil pricing. The correlation between oil price and the stock market can change as the two charts below demonstrate. The reason is simple: a supply shock will generate a negative correlation between oil and the stock market. The example we chose is the 1990-1991 period during the first Gulf War.
Chart 2 clearly shows that oil prices were driving the S&P down. Conversely, if oil prices move because of greater demand, the correlation with the S&P is positive. In our example (Chart 3), the phase of strong growth at the end of the 1990s was associated with rising stock market and oil prices and indeed both oil prices and the stock market fell at the end of 2001 when growth faltered.
So the implication of a surge in oil prices on risky assets would be straightforward: the impact on growth as well as the impact on risk appetite would push risky asset prices down.
The correlation with safe havens, especially risk-free rates, is much more difficult to analyse. Indeed, the economic slowdown from a surge in oil prices should reduce yields, but the surge in inflation should increase yields. The easy part of the curve to forecast is thus break-even inflation (BEI), and indeed the short part of the BEI curve is highly correlated with energy prices, which contribute to a large share of the short-term volatility in actual inflation.
What does recent history tell us? The following chart shows that since the beginning of the year both oil prices and yields have steadily increased in tandem. We would attribute that essentially to a demand effect: the improvement in the world economy is consistent at the same time with higher rates and higher oil prices. However, it seems clear that on a number of occasions (the three short periods highlighted below), the move in oil prices was opposite to the move in yields. This suggests that if the oil price move is too quick, for instance on the upside, it signals risk for growth and risk aversion mounting on the back of geopolitical issues; both bringing yields down.
In short, nominal rates would go down if the surge in oil prices is sufficient to threaten the recovery.
The second impact on markets would be via a reduction in risk appetite. When the crisis escalated, or was perceived to escalate, we saw the familiar “risk-off” rush with Treasuries and other forms of risk-free assets rallying while the risky or high-beta plays were selling off. This is a pattern we have seen repeatedly in the past. Hence, we ran some analysis on exactly what are the safe havens and what are the sectors most penalised by a jump in risk aversion.
The way to take into account a jump in risk aversion in the asset allocation space is to produce an investment clock depending on risk. The following chart shows the dependency of asset class performance on the level of risk aversion and the change in risk aversion.
We find that the usual suspect (cash) is a good hedge and the only other asset class that would provide protection in this circumstance would be core government debt. Interestingly, we find that both the Treasury market and US linkers would perform, but also gilts and JGBs. Why not also European bonds? Probably for two reasons: firstly, because we take USD indices and the EUR has historically depreciated in these circumstances; and secondly, because the European bond index is not a risk-free rate but an average of all European sovereigns, hence it underperforms when spreads widen.
In conclusion, we believe the only asset class that would provide protection to both the economic downturn and the jump in risk premium is the US curve, particularly the very short-dated part, which we call “cash” in our portfolio, or the longer-dated part, whether in real or nominal terms. The only decision would thus be a duration bet on the US curve.
Currently, we are in the “medium and falling” risk-appetite regime where historically it has been best to short equities and inflation-linked bonds and go heavily overweight in developed market corporate bonds. When risk appetite starts to rise again (“medium and rising”), the position becomes short government bonds and long corporate bonds and long equity. If the rally continues to high-risk appetite, the profile remains the same, with more aggressive positions in equity and credit.