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The Israel/Hamas Conflict Explained (How It Matters to Markets)

October 17, 2023

The Hamas attack on Israel two Saturdays ago and the future Israeli response have dominated the mainstream and financial news. And with the situation set to potentially escalate in the coming days, I wanted to provide a dedicated analysis to explain what this situation means for markets. 

I will not spend time addressing the human aspect of the situation other than to say it is a tragedy of epic proportions for all innocent civilians, and our hearts go out to the families that have lost loved ones and whose lives have been torn apart. 

The reason I won’t spend time here on the human aspect of this situation is because it doesn’t matter to the markets. The market is only focused on the economic impact of the conflict, and that’s why tragedies don’t usually impact markets unless they carry with them economic consequences. 

Looking at the Israel/Hamas situation, like most geopolitical crises, the market views it through the lens of impact on energy commodities, and in this situation, that means oil. For reference, the Ukraine/Russia war was viewed through the lens of a different commodity, natural gas. 

So, for the Israel/Hamas conflict, here are the market truths: 

1. Anything that occurs that the market thinks might reduce the supply of oil will push oil prices higher and stocks lower. 

2. If markets do nothing, the war will affect the oil supply, and then the markets will largely ignore the war, regardless of the human tragedy or geopolitical upheaval that ensues. 

Given those truths, here is the worst-case scenario for the market. First, Israel invades Gaza. This is extremely likely to happen. Second, Hezbollah attacks Israel in retaliation on their northern border through Lebanon, creating a two-front conflict for Israel. 

Third (and this is the key point), Iran attacks Israel to support Hezbollah and Hamas, which prompts the United States to launch an attack on Iran, almost certainly destroying much of its oil infrastructure and removing supply from the market. To underscore this risk, South Carolina Sen. Graham will introduce legislation authorizing the president to destroy Iranian oil infrastructure in the event of an attack on Israel. 

That is how this conflict goes from isolated (Israel vs. Hamas or Israel vs. Hamas/Hezbollah) to regional (Israel and the U.S. vs. Iran, Hamas and Hezbollah). And that’s when this conflict would materially impact markets and send oil prices surging. 

Absent this spiraling into a regional conflict (whereby Iran gets involved and the U.S. threatens to attack its oil infrastructure) then this conflict should not materially impact markets beyond the very short term. 

Notably, this dynamic is why stocks rallied on Monday. News that President Biden may travel to the regional was seen as an effort to prevent a broader regional conflict and as long as diplomatic progress occurs, that will pressure oil and help support markets. 

Bottom line, for all the noise that will occur in the coming days, watch oil prices, because that is the barometer of the market’s worries about a regional conflict. If oil makes a fresh closing high above $87.72 on an Israel/ Gaza/Hamas/Hezbollah/Iran headline, that’s a clear indicator the situation is legitimately deteriorating and increasing the risk of a pullback in stocks. 

According to the Congressional Budget Office, federal spending should total $6.131 trillion in the fiscal year that ended on September 30. But that includes the effects of the Supreme Court striking down much of President Biden’s plan to forgive student loans. That decision created a $333 billion “negative outlay” for Fiscal Year 2023. Without that decision, which didn’t affect the government’s cash flow, total federal spending would have been $6.464 trillion. We estimate that would translate to 24.0% of GDP in a year when the jobless rate averaged 3.6%.

Let’s put that in historical perspective. In FY 2019, the last year prior to COVID, the jobless rate averaged 3.7%, and federal spending was 21.0% of GDP. Back in 2000, at the peak of the first internet boom, federal spending was 17.7% of GDP. Some of this increase is due to higher interest costs, but most of it is not, and the trend is not good.

Understand that this is not sustainable. Federal, State, and Local spending is already roughly 42% of GDP. If we don’t get spending under control, tax rates will eventually go much higher. Bigger government means less innovation, less investment in and maintenance of capital, and less economic growth.

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