PGIM Fixed Income: The implications of the Israel-Hamas war for investors

17 oktober 2023

Daleep Singh, Chief Global Economist at PGIM Fixed Income en former advisor of Joe Biden, comments on the Israel-Hamas war.

Despite statements by US officials suggesting inconclusive evidence of Iran’s role in backing the attack, we think Iran’s role in supporting, financing, and coordinating the attack is beyond doubt.

In August last year, IRCG commander Hossein Salami expounded Tehran’s strategy how to defeat Israel. He reportedly argued that Hezbollah and Palestinian militias must conduct ground operations and urban combat inside Israel. Such activities, according to him, would generate internal displacement and sow chaos, which would ultimately destabilize Israel and lead to its decline.

Meetings that IRCG has recently held with leaders of the so-called 'Axis of Resistance' in Syria and Lebanon almost certainly have focused on how to implement this strategy. 

The timing of the attack was no coincidence.  Deep political divisions within Israeli society over a deeply controversial set of judicial reforms, threats by military reservists to quit service, and the military’s focus on the West Bank distracted Israel’s attention from the Gaza threat and created tactical opportunity for Iran to exploit. On October 2, according to a WSJ report, the IRCG greenlighted the Hamas operation.

At a deeper strategic level, the attack from Hamas is an effort to restore Iran’s standing against Saudi Arabia in the region.  For context, Israel and Saudi Arabia were on the cusp of a normalization process that likely would have included a formal US security commitment to Saudi Arabia in exchange for Israeli concessions to Palestinian rights. The deal would have entrenched America’s dominance in the Middle East for years to come, dealing a blow to Tehran’s strategic goal of driving the US out of the region and isolating Israel.

In the wake of the attack, the normalization of relations between Israel and Saudi Arabia is now on hold for the foreseeable future, if not completely dead. The Saudis, who compete with Iran for de fact leadership of the Islamic world, have no choice but to condemn Israel for creating the conditions that led to the attack. The Palestinians will get neither the statehood nor the concessions that the process might have produced.  From Iran’s point of view, this is a huge strategic win.

In response to the attack, the Israeli government has formally declared a war on Hamas and is reportedly preparing for a ground offensive inside Gaza - with the express purpose of eliminating Hamas as a terrorist entity.

The operation will neither be easy nor quick: first, because Iran and Hamas have likely prepared for such an eventuality, setting up IDF forces for a military trap inside Gaza; and second, if Hamas is pushed to the brink of elimination, Iran may call on better-equipped members of the Axis of Resistance for support (especially Hezbollah), opening up a multi-front war against Israel and risking the escalation of conflict spreading to the rest of the region.

Below we lay out the main scenarios that we see unfolding over the next 3-6 months. In our view, much depends on whether Russia, China, and the United States can prevail upon Iran and Israel to avoid an escalatory tit-for-tat that engulfs great powers in another proxy conflict.

Our hunch is there is just enough collective incentive to prevent an uncontrolled spiral, but much depends on Israel’s willing to avoid a maximalist response in the next few days. Regardless of the outcome, the episode serves as another grim reminder of a central thesis that underpins our forecasting: we have returned to a global backdrop of intense geopolitical competition – the shocks will just keep coming.

Main Scenarios  

Long, drawn out conflict limited to Gaza (55% probability): Conflict remains limited to Gaza. Israel faces significant resistance by Hamas operatives. Military operations stop short of maximalist aerial bombardment that would generate untold civilian casualties and lead to international condemnation.  Iran opts not to call for multi-front war. Qatar and Egypt, despite the latter’s decline of influence on Hamas, remain engaged. China pushes Iran not to escalate in a gesture of goodwill to KSA, and due to its own interest in avoiding another spike to oil prices. 

• Market impact: Temporary spike of Brent oil prices (~5%) and brief flight to quality in risk-free assets. No lasting impact to risk sentiment or central bank reaction functions.   

Conflict metastasizes into proxy war (40% probability): Wounded by an intelligence failure of historic proportions, Israeli PM Netanyahu launches an unrestrained campaign of destruction in Gaza City, leading to thousands of Palestinian casualties. Israel’s response is perceived as disproportionate and widely condemned, triggering Hezbollah to launch a second front in the war from Lebanon (and possibly a third in the West Bank by Islamic Jihad). Israel is poised for counterstrikes on Iranian targets, and the conflict becomes yet another proxy battle between the US and Russia. China and Saudi Arabia both stand back, content in the sowing of chaos that further undermines US hegemony and dents President Biden’s re-election prospects.   

• Market impact: Sustained spike in Brent oil prices (15-20%+) and bull steepening of fixed income curves in response to negative supply shock and rekindled risk of global recession. Additional cuts priced into interest rate forwards along with higher market-implied inflation breakevens.  

Return to status quo ante (5% probability): Israel determines that rooting out Hamas as a military and political force in Gaza is futile; instead it opts to harden its defenses and resume the normalization process with Saudi Arabia. US, Russia, and China sponsor a multi-year mediation process.   

• Market impact: negligible

A few other thoughts: 1/ ahead of Nov 2024, strap in for more shocks: you’ve heard me say that we’ve returned to a period of intense geopolitical competition that markets haven’t needed to discount in at least three decades; this episode of course serves as a grim reminder of that reality, and I fear that in the runup to the US elections next November, the geopolitical shocks rippling from this backdrop will likely occur at greater frequency.

Why?

To the extent that revisionist powers (e.g., Russia, Iran, DPRK, China) have an incentive for a return to isolationism in US foreign policy, they are more likely to 'exercise their option' and sow chaos & disarray before the US election, when their leverage is arguably at a local maximum; 2/ the technology of warfare is shifting rapidly: Israel’s seemingly impenetrable shield of intel, missile defenses (the 'iron dome'), and border security was pierced by a low tech combination of cheap rockets and small drones that knocked out Israel’s expensive sensors and tanks. This in many ways echoes the initial success of Ukraine’s much smaller but technologically sophisticated military against legions of Russian tanks and planes.

Takeaway: new technologies are leveling the playing field of conventional warfare, making it even more likely that we’ll see export controls on any item with a military application, and less likely that political authorities will allow high tech to diffuse freely across borders for commercial purposes; 3/ connecting the dots to US fixed income: beyond the proximate effects that we laid out in the summary of scenarios, there is a more speculative, second-order effect to consider.

National security experts are abuzz with discussion about whether the US defense-industrial base has sufficient throughput capacity to back Ukraine, Israel, and possibly Taiwan with artillery and munitions in a simultaneous and extended conflict scenario. The unanimous and emphatic answer from experts is 'no', which to me just underscores the likelihood of a period of fiscal dominance in which deficits are mostly disregarded and interest rates must adjust to a higher equilibrium.