20 June 2014

Macro Strategy Update

Middle East Developments

Executive Summary: The conflict in Iraq has caused some concern manifesting in slightly weak markets and a short term rise in oil prices. However, we do not see a full blown conflict occurring and any effects are expected to be modest given the low share in Iraq’s global oil production. However, we are mindful of this tail risk and will watch the developments closely should something more significant occur.

Portfolio Positions: Our view remains unchanged. We will look to take off our slight equity underweight position and neutralize all portfolios. Within our equity allocation, we will have an overweight in the US and European markets. Our fixed income exposure will be slightly diversified out of investment grade corporates to prepare for the eventuality of rising interest rates.

Article

Introduction
Recent developments in Iraq have unnerved markets and the financial media. The successful incursion of Northern Iraq by the Islamic State in Iraq and the Levant (ISIS) has investors fearing a disruption to global oil supply and a subsequent spike in prices which could slow down the global economy. We are aware of this tail-risk and its possible implications, but find insufficient reasons to panic about the potential negative impact on financial markets.

The Protagonists
It is important to understand who the ISIS is. This will allow us to determine their objectives, establish how events may play out and how energy prices will react. Several websites have constructed a good profile of the ISIS. In short they are a well organised splinter group from the Al-Qaeda, subscribe to the Sunni branch of Islamic teachings and excel not only in military tactics, but also in governing, communications and business. Their stated goal is to establish a Sunni caliphate in the region bordering Syria and Iraq. This is not surprising as the majority of the population in Northern Iraq are Sunnis and are not supportive of the Shia government in Baghdad. This is likely why ISIS was able to capture Mosul, Iraq’s second largest city so quickly as desertion was wide spread.

Shias and Sunnis
Conflict between the Shias and Sunnis in Iraq go back to the 60’s since the start of the first Kurdish-Iraqi war. Whilst Sunni Muslims are the majority in the world (over 85%), in Iraq they have always been the minority. During this recent conflict, there are reports that the Iraqis in Mosul are supporting the ISIS as their liberators after years of oppression under the Shia government. The probability that the ISIS will consolidate their captured territory, rather than march south towards Baghdad and the oilfields in the South, is high. It would be difficult to govern a territory whose population is at odds with you ideologically. It would also give Iran, a Shia nation and a key supporter of the government in Baghdad, an excuse to support them by sending troops and supplies. This is not an outcome the ISIS wants, especially when the size of its fighting soldiers, estimated at around 7,000, is dwarfed by Iran's 700,000 strong army.

Western Involvement
Another dimension of this situation is how Western nations will respond. What happened with Syria has shown that it is likely to be a half-hearted response from the West, with the US determined not to send troops and drawn into yet another war. Our view is that as long as ISIS does not move into Shia territory, there will be limited involvement by the US although rhetoric will increase. Investors need to note that whilst Iraq has around 9% of the world’s oil reserves (Fig 1), the country accounts for less than 4% of the world’s production (Fig 2). The conflict would not materially disrupt the demand supply balance and probably the reason why we have not seen a spike in the relative performance of oil versus a major index like the S&P 500 (Fig 3).

Fig 1: Proven Global Oil Reserves

Fig 2: Oil Production as at End 2013

Image courtesy of Stockcharts.com

Fig 3: No Spike Seen in Oil Price Relative to S&P 500

Conclusion

We do not see a full blown conflict in the Middle East which would cause oil prices and risk aversion to rise significantly. In the shorter term, some concerns could manifest in the form of higher oil prices and weakness in the market. However, we are monitoring the situation in the event that it becomes a significant tail risk which could affect our asset allocations and positions.



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