For equity investors, the fear is that tensions between Tehran and the West will cause a disruption to the free flow of crude oil, which acts as the lifeblood of the world’s economy.
“It would certainly be a blow to confidence,” said David Joy, chief market strategist at Ameriprise Financial. “The global economy is still pretty fragile. This recovery is just starting to gain a little bit of traction in the U.S.”
Spotlight Shifts to Tehran
For the better part of the past six months, Europe’s scary and seemingly never-ending sovereign debt crisis has held the top spot as the biggest threat to the U.S. stock market.
While concerns about the eurozone’s ability to fix its problems persist, they have been soothed significantly in recent months.
Emergency actions executed by the European Central Bank appear to have removed the threat of a Lehman Brothers-like banking crisis, while the recent Greek bailout deal has eased fears Greece will suffer a disorderly default in the near term.
“We see a shift from the focus on Greece and the EU to more on the increasingly-inflammatory rhetoric between the U.S. and Iran,” said Kirk Howell, chief operating officer of Kiodex, SunGard’s energy and commodities business.
Luke Aucoin, chief operating officer and portfolio manager at Vista Research and Management, agrees that Europe has now begun to take a backseat to Iran.
“We spent all weekend looking at Greece, but we probably should have been looking at Iran,” said Aucoin.
Energy Prices on the Rise
Over the weekend Iran pledged to stop exporting crude oil to U.K. and French companies, reigniting concerns about a supply shortage. The move appeared to be in response to new European Union sanctions aimed at bringing Iran back to the nuclear negotiation table.
The latest tensions between Iran and the West sent crude leaping 2.52% a barrel on Tuesday to $105.84 -- its highest settle since May 4, 2011 -- where it continues to hover Wednesday. Fueled largely by the Iran fears, crude has soared $5.10, or 5.06%, over the past five sessions and is off just 7% from its 52-week high of $113.93 set last April.
Meanwhile, the price of regular gasoline climbed to $3.56 a gallon, the highest level ever for this time of the year, according to AAA.
All of this is not to say that Wall Street believes Greece or the eurozone crisis is solved. On the contrary, market participants seem to be banking on future Greek bailouts and believe new troubles in other struggling nations like Italy and Portugal can’t be ruled out.
“I think we’ve played out the whole Greek tragedy to the 'Nth' degree. Everybody knows that this is not the end,” said Marc Pado, U.S. market strategist at investment advisory DowBull.
Markets Mull Iran Scenarios
While more trouble is expected in Europe, few know what’s in the near future on the Iran front.
Likewise, a near-term resolution like the Greek bailout doesn’t appear to be in the offing, though some are holding out hope the new sanctions will force Tehran’s hand.
“Iran is a pressing issue. It’s one that is day-to-day and hour-to-hour being watched closely,” said Pado. “Oil prices can move very significantly on fears.”
There are many potential Iran scenarios that could hit the U.S. stock market, but the scariest one is an all-out war in the region that would almost surely cripple the flow of oil out of the Persian Gulf.
Investors should also be concerned about the potential repercussions of an Israeli airstrike on Iranian nuclear facilities.
Iran has already threatened to shut down the Strait of Hormuz, where 17 million barrels of crude, or 35% of the world’s seaborne oil shipments, pass through each day. A shutdown of this crucial waterway would likely be met by a military response by the U.S. Fifth Fleet.
Crude Spike Would Hit Recovery
The ongoing saber-rattling “is going to prove to be an enormous headwind for the market because any further increase in the price of energy is going to act as a drag on GDP expansion,” said Peter Kenny, managing director at Knight Capital Group.
That’s because crude oil impacts such a broad swath of the economy. Higher oil prices will eat into consumers’ ability to spend on everything from clothes at Target (NYSE:TGT) to Apple’s (NASDAQ:AAPL) iPads.
A spike in crude would also put further pressure on businesses that rely on oil to transport goods as well as manufacturers of many of them, such as tires and plastics.
“A dramatic impact on the price of energy will pinch confidence and market participants will largely go into a lockup in terms of their allocation because of their lack of clarity,” said Kenny.
Is Iran Priced In?
It’s very hard to quantify the precise chances of a military confrontation with Iran, particularly because of all of the moving pieces and questions surrounding the Iranian regime.
Joy said he believes the chances of a military engagement are less than 50/50.
“This is one of those events that it’s awfully difficult to say, ‘I really need to change my portfolio to prepare for it,’ because you should already have built in some flexibility anyway. It’s kind of a wild card,” said Joy.
He said investors should own crude oil and other commodities that would be impacted by an Iran conflict as well as defensive stocks and safe-haven assets like short-term bonds.
While the energy markets are already displaying a risk premium associated with the Iran jitters, the U.S. equity markets may not be discounting this threat yet.
After all, the Dow eclipsed the 13000 mark on an intraday basis this week for the first time since May 2008, building on its impressive 21% rally since the October lows.
“I would say very little of that is priced in right now,” said Joy.