As the Middle East explodes, how should investors position themselves?

Iran launched the strikes in retaliation for Israel's campaign against Tehran's Hezbollah allies in Lebanon

Highlights

• Iran holds limited significance on the trade front
• Oil market disruption in Western Asia can hamper India’s interests
• Recent policy developments in the US and China positive for global equities
• Indian markets remain well supported by domestic liquidity
• Correction should be used to add domestic demand-driven picks 

From the market viewpoint, the comforting aspect is that none of these events were complete surprises. They were events that were being discussed and the extent of change that will play out is what remains to be assessed. However, the confluence of all these factors may keep the markets on tenterhook – particularly the war in Western Asia as it can have a direct impact on the real economy.

What does a bigger regional conflict mean?

Local conflict between Israel and Hamas has spiralled and now includes Yemen, Lebanon and Iran. Iran’s ballistic missile attack on Tel Aviv is likely to invite a retaliatory response from Israel which can also potentially drag the US into the conflict. Iranian-backed Iraqi armed groups have warned about targeting US bases in Iraq.

Expanding conflict region

Source: Google Maps

A wider regional conflict may further hamper commercial shipping through the Red Sea route. However, it may not materially impact global commerce as a large part of the Red Sea bound trade has been taking the Cape of Good Hope route for the past many months. Indian exporters have largely adjusted to longer transit times.

Similarly, further isolation of Iran would not have any significant direct impact on India’s export-import. Due to earlier sanctions, Iran’s trade contribution has visibly reduced over the years.

That said Western Asia (UAE, Saudi Arabia, Iraq and Kuwait) contribute 43 percent of India’s imports of crude oil. Though in recent years, supply of Russia Oil (38 percent share in India’s import) has provided a much needed hedge, a wider and longer conflict could adversely impact India both from the pricing and supply perspective.

What should investors do?

Before jumping to conclusions, investors should take note of the multi-layered investment context – global macros, flows, valuation and sentiment.

Strong earnings traction by US companies, recent GDP data and FOMC projections point towards a soft landing for the US economy. Further, recent comments from Jerome Powell tempered expectations for aggressive interest rate cuts which also allays concerns for the local labour market.

Among major economies, consumption slowdown in China has been the key worry point but the recent series of stimulus measures (including issuance of $284 billion of sovereign debt) may help in arresting deflation and reduce the menace of goods dumping across the globe. Indian economy, at the same time, remains solid with the IMF predicting 7 percent growth this year.

Further, net flows to Indian market have been reasonably robust in recent years – primarily driven by domestic inflows. Since the start of 2021, net inflows to Indian equities have been to the tune of $175 billion wherein more than 90 percent of the flows are attributed to DIIs and individuals (includes HNIs).

In the month of Sept, FIIs did pour in $6.9 billion – largely in anticipation of Fed’s rate cut cycle. While this recent jump in flows may soften due to value bets on Chinese equities, we believe that the interest rate differential between India and the USA would be a key driver of flows. That said, in the larger scheme of things, domestic flows remain a major bulwark of liquidity. SEBI’s recent restrictions on the F&O segment may also divert liquidity towards the cash market.

Key worry for valuation is earnings growth

However, what makes the Indian market vulnerable to a wider military escalation is valuations. The gap between the Nifty earnings yield and the 10-year G-Sec yield is closer to the average gap during historical market peaks.

And hence, in coming weeks, a shallow correction can be anticipated. Interestingly, historically, war-like situations have not materially depressed stock markets of distant nations. A study by Omar, Wisniewski, and Nolte (2017) analysed the impact of 64 instances of severe international crisis and in the time window of 100 days, returns of S&P 500 were down by 4.7 percent only.

While the Western Asia war is a developing situation and the US Presidential election is another major event ahead having global trade ramifications, Q2 FY25 earnings would be more crucial for the justification of the Indian market’s valuation as it would test some pockets of stress (like slowing consumption).

While oil price sensitive and/or oil derivative sectors would likely see a knee jerk reaction, sectors that have a domestic focus and with strong earnings visibility remain the key area of interest and should be added during corrections. Investors should resist from adding more small cap exposure and largely tilt towards large-caps and quality style of investment.

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