Will the Crisis in Syria Shock the Markets?

U.S. military action in Syria appears imminent. Assuming it happens, what happens to the financial markets?

Investor reaction on August 27 (the day U.S. intervention was mentioned as a possibility) was not exactly surprising. Gold entered a bull market again, oil prices reached a six-month peak (surpassing $109 a barrel), the Dow fell 170 points and the CBOE VIX rose 12%. Overseas markets broadly slumped; emerging market stocks hit a 7-week low. India’s rupee fell to a record low versus the dollar. The yield of the 10-year Treasury dipped to 2.72%, decreasing for a third straight day. All of this left market analysts with major questions to consider.

Will oil hit $150 a barrel? While U.S. investors keep an eye on the NYMEX, the international benchmark is Brent crude. Some analysts do see Brent crude hitting $120-125 in the coming weeks – Michael Wittner, global head of oil research for Societe Generale, told CNBC that he believes that will happen, in the event of military intervention. Wittner also thinks that Brent crude has about a 20% chance of pushing past $150, but not wholly on what goes on within Syria. “Our big worry is Iraq. The Sunni vs. Shiite conflict in Syria has a direct parallel in Iraq, and the violence in Iraq has reached levels not seen since 2008,” Wittner wrote in a note to investors. A key oil pipeline in northern Iraq ferrying oil to Turkey has endured multiple attacks since May, severely hampering Iraq’s daily oil exports. Other analysts worry about attacks on pipelines in Saudi Arabia.

On the other hand, U.S. oil output is at a 20-year peak, and Saudi Arabia and other major players in the oil market could tap strategic reserves or increase production in response to a short-term price spike. As business and consumer demand for oil and gasoline typically weaken at some point in response to price hikes, prices would likely moderate.

Greg Priddy, director of global oil at Eurasia Group, told CNBC that he doesn’t see a big disruption in the oil market ahead – he envisions a “very limited attack” that is “not going to change the situation in the region right now.” As toppling Bashar al-Assad’s government could put rebels in charge but also risk opening a door to al-Qaeda, the view of some analysts – Brent crude temporarily hovering around $120, U.S. oil prices keeping below that level – may prove correct. “This would have to turn into a region-wide conflagration in order for prices to stay [at that level],” John Kilduff of Again Capital remarked to CNBC. “If rockets start flying into Gaza and into Israel and other things happen, such as an attack on Saudi Arabia, all bets are off.”

Would U.S. stocks plunge? The Dow is on pace for a decline of more than 5% in August, so bears wonder if a correction is in progress. No one has a crystal ball, but it is true that the U.S. equity markets have weathered geopolitical crises well in the recent past. Our stock market rose in the year prior to our military’s involvement in Libya in March 2011, fell  that summer, then rose again. The fall coincided with the debt ceiling struggle on Capitol Hill, not the unrest in Libya. In the case of the Persian Gulf War and the War in Iraq, U.S. stocks were in the doldrums in the quarters preceding the fighting yet rose about the time hostilities began.

As MarketWatch columnist Mark Hulbert commented this week, “Rising interest rates and above-average valuations are a bigger threat to the stock market than the possibility of U.S. military action in Syria.” Opening a wide historical window, he cites a fundamental article from the Journal of Portfolio Management co-authored by none other than Larry Summers, who stands a chance of being our next Federal Reserve chairman. It looked at the impact of 49 major geopolitical events on the stock market from 1941 to 1987, measuring the S&P 500’s absolute return on those momentous days (Pearl Harbor, the assassination of JFK, etc.). The S&P’s average movement across those 49 days was 1.46% : significant, but not radically removed from the average 0.56% variance occurring  across all other market days in a 46-year period. For the record, the S&P rose 0.60% on August 28 while the CBOE VIX dipped 3.6% to 16.17.

Could this crisis make the Fed reconsider tapering? Recent days have seen a real flight to quality – to gold, to the dollar, to Treasuries.  You have a couple of currencies seemingly in freefall: the Indian rupee and the Turkish lira. For that matter, Brazil’s real recently hit a five-year low versus the greenback. Indonesian stocks just dropped 5% in a single market day. In short, some key emerging markets/developing economies are having it rough – and a lack of economic growth in those nations may not bode well for America. If the trouble in Syria worsens and leads to further trouble for them, some analysts think the Fed might postpone the careful unwinding of QE3 – either out of caution, or out of global economic necessity.

The takeaway? As Ron Florance, a deputy CIO at Wells Fargo Private Bank in Scottsdale, Arizona, told Reuters on August 28: “Yesterday was a little overdone but investors need to be ready [and realize] that volatility is going to be here for a while.” Just think twice before letting short-term volatility affect long-term investment plans.