The markets' curious reaction to the Middle East crisis

One of the many unusual things about the Middle East crisis is that many markets still seem reluctant to treat it as a crisis. Take stocks. Yes, markets have fallen since 28 February, but still by far less than you'd expect given the scale of the conflict, the disruption to global energy supplies and the complete uncertainty about how long this may go on.

At the time of writing on Wednesday, the MSCI World index of developed markets is down by about 5.5% in sterling terms. The MSCI Emerging Markets is worse, down about 10%. This is not nothing, but it is considerably less than most investors would have expected in response to Iran closing the Strait of Hormuz.

Still, there is obviously some variation within this. The US continues to hold up better than most of the world (down 4%). Energy has rallied as you'd expect – the MSCI World Energy is up about 10%. Tech stocks have been fairly steady. Cyclicals such as consumer discretionary, materials and real estate have mostly done poorly.

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Yet defensives such as consumer staples and healthcare have also been very weak, which is unusual at times of stress. This may partly reflect fears about input costs – many of which are affected by oil and gas prices – and the challenge of passing those on when incomes are under pressure, but it's not entirely easy to justify.

Little room for safe havens in the Middle East crisis

In fact, safe-haven trades in general are not really doing what you'd expect in the Middle East crisis. The US dollar is stronger against other currencies on average, but not by much. Gold has fallen by about 15% – very much at odds with its reputation. One popular explanation for gold's weakness is the prospect of higher interest rates – these are typically viewed as a headwind for gold, all else being equal. Another is that after such a strong run-up over the past year, investors – especially those with leverage – decided to dial down their risks by taking some profits.

Bonds have also been no sanctuary; they have fallen in response to the threat of higher rates. Yet even here, the story is not clear. Medium and longer-term bond yields are up – the 10-year gilt soared from 4.2% to over 5% – which sounds as if markets are pricing in higher inflation. Yet yields on inflation-linked bonds have marched in lockstep with conventional bonds, meaning that inflation expectations are unchanged (see above for US bonds, the UK is similar).

Can we make much sense of this? Maybe. There is some optimism that the Middle East crisis will not be too prolonged or stocks would be doing much worse. Still, markets are anticipating slower global growth, with the US coping better than the rest. They expect central banks to run tighter monetary policy in response to the threat of inflation, but the medium-term impact on inflation should be muted. There's a desire to reduce risk (hence profit taking in gold), but not to be too defensive because the last decade has shown that defensiveness doesn't pay. All told, it's plausible, but it is the best-case scenario. Doubts must rise if the war lasts much longer.

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