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Geopolitical Risk Awakens

Wells Fargo Investment Institute - January 6, 2020

by Paul Christopher, CFA, Head of Global Market Strategy and Darrell Cronk, CFA, President of Wells Fargo Investment Institute, Chief Investment Officer of Wealth and Investment Management

Key takeaways

  • A second U.S. airstrike within a week hit Iranian military personnel in Baghdad on January 2, and Iran has threatened significant retaliation.
  • On January 3, President Trump said, “We took action to stop a war.”(CNN) However, the Pentagon announced Friday that it will send additional troops to the region.

What it may mean for investors

  • These events have not changed our outlook for U.S. equity earnings growth, which we believe will be in the mid-single digits in 2020. And the events have not changed our oil price targets, which already reflect a reasonable geopolitical risk premium. That said, if tensions escalate, defense stocks may see a new bid higher, and emerging market equities may come under pressure.

A second U.S. airstrike within a week hit Iranian military personnel in Baghdad on January 2, and Iran has threatened significant retaliation. The Pentagon confirmed the killing of Gen. Qassem Soleimani, the influential Iranian general and the top commander of dozens of Iranian-funded and trained militia groups operating in Lebanon, Syria, and Iraq. 

Gen. Soleimani was not only a high-ranking commander—the equivalent rank of U.S. commanding generals in Iraq and Afghanistan—but he was instrumental in organizing, building, and extending Iran’s ability to fight anywhere in the Middle East, and even the world, without using formal military forces. In other words, he was the mastermind behind Iran’s strategy of waging war with plausible deniability. One of those Iranian-funded militia groups, Kataib Hezbollah, in recent weeks attacked U.S. and allied Iraqi military positions and the U.S. embassy in Baghdad. Its leader is an unconfirmed fatality in the U.S. strike. 

Global markets appeared to respond initially by reducing risk appetite. The S&P 500 Index lost 0.7% on January 3 and opened approximately the same amount lower again on January 6. Oil prices rose in the two days following the event. The West Texas Intermediate (WTI) and Brent oil prices rose to $63 and $68, respectively, but remained within our 2020 target ranges.

Potential political and market implications

We believe there are likely domestic and international political implications for U.S. investors: 

Geopolitical implications: Iran has a demonstrated capacity for significant economic disruption. The Trump administration cited U.S. intelligence assessments that officials called evidence of Iranian involvement in the missile attack on the Abqaiq and Khurais oil-processing facilities attacks, which temporarily took down half of Saudi Arabia’s oil production, nearly four months ago.1 As potential economic or market disruptors, we believe Iran could retaliate by directing any of its many paramilitary forces to attack U.S. interests anywhere in the Middle East, including by missile attacks against Saudi Arabia or Israel, by attack boats against oil tankers in the Persian Gulf, and by a variety of means against U.S. military personnel in Afghanistan and Iraq. Support from China and Russia for Iran could blunt U.S. diplomatic efforts to punish Iran. 

On January 5, the Iraqi Parliament approved a non-binding resolution directing the government to order U.S. troops out of Iraq. However, it is unclear whether Iraq’s caretaker prime minister has authority to carry out the resolution. The Wall Street Journal noted in a January 5 article (“Iraqi Parliament Votes in Favor of Expelling U.S. Troops”) that Iraq’s Sunni and all but one of its Kurdish lawmakers—nearly half the chamber—did not attend the special parliamentary session. This split in Parliament underscores Iraq’s persistent sectarian divisions. If Iran’s influence over the legislature and the militias in Iraq eventually drives the U.S. out of Iraq, then an additional geopolitical risk is that ISIS may accelerate its resurgence in the vacuum.

Domestic implications: U.S. Defense Secretary Mark Esper in recent weeks made comments suggesting that U.S. forces in the region would begin to shift to other areas (Asia and Europe). However, any such plan appears to be on hold as the Pentagon announced Friday it will deploy additional troops to the region. President Trump’s October 2019 order to withdraw U.S. troops from Syria suggests to us the U.S. wants more limited involvement in the Middle East, but we could see more market volatility if Iran pushes U.S. officials to either commit more troops or withdraw. We believe this implies more volatility for markets and probably an increasing international focus on the campaign trail.

Our perspective

We continue to believe that earnings growth will be in the mid-single digits in the U.S. in 2020, but investors may rethink their desired valuation on equities, if geopolitical escalation persists. Additionally, if these tensions escalate further, defense stocks may see a new bid higher. Emerging market equities may come under pressure if risk premia escalate with political uncertainty. 

Our $55-$65 WTI and $60-$70 Brent 2020 target ranges already bake-in a $10 geopolitical premium, specifically due to Middle East turmoil, which has been brewing for some time now. We believe Middle East geopolitics are likely to stay tense in the future, but relatively weak oil fundamentals should keep prices from sustaining much higher levels, even as Middle East turmoil ebbs and flows. We remain comfortable with our 2020 WTI and Brent target ranges.

Our 2020 Outlook—A Call for Resilience highlighted ongoing geopolitical risk in 2020 as an ongoing market disruptor. The following reprise our guidance, given the latest events:

1.    Focus on quality: For quality, we focus on U.S. based large-cap companies with sizable cash positions, strong balance sheets, and growing dividends or share buybacks. Two equity sectors that share these characteristics are Information Technology and Consumer Discretionary. Within fixed income, we focus on reallocating from low-quality high-yield, in favor of highly rated U.S. corporate bonds.

2.    Defense can be a good offense: Hedge fund strategies that can profit in both up and down markets may provide a good alternative late in the economic expansion for qualified investors. Over the next few years, we favor Relative Value and Equity Hedge strategies. In addition, investors can play defense with their equity sector allocations. We favor holding market-weight exposure in the defensive Consumer Staples, Real Estate, and Utilities sectors, and we are unfavorable on the Materials and Communications Services equity sectors, which we expect to underperform in a late-cycle economy.

3.    Focus on longer-term diversification as shorter periods are likely to be volatile: Historically, large-cap equities have experienced pullbacks of 5% or greater 3-4 times per year and corrections of 10% or more every year or so. Investors can reduce short-term volatility risk by using cash tactically, focusing on high-quality assets, and positioning into more defensive asset classes and sectors. One of the best long-run approaches has been to diversify across a combination of low-correlated assets and regularly rebalance back to strategic targets.

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1New York Times, “Who Was Behind the Saudi Oil Attack? What the Evidence Shows”, September 16, 2019.