The stock market's response to geopolitical tension hasn't followed the old script. Here's why.

By Isabel Wang

Geopolitical events tend to have a larger impact on the stock market when they trigger stagflation, Deutsche Bank notes

One year after the terrorist attack by Hamas and Israel's ensuing war in Gaza, the tension in the Middle East has only heightened, drawing the attention of market participants the world over.

Yet while the widening geopolitical conflict recently pushed oil prices (CL00) (CL.1) (BRN00) to their biggest weekly gain since at least early 2023, risk assets like U.S. stocks, albeit volatile, have moved relentlessly higher to score multiple records this past year - to the surprise of many investors.

Historically, major stock selloffs driven by geopolitical events have mostly happened when the U.S. economy was on the brink of stagflation - when slowing economic growth and high inflation occur at the same time, a major fear of investors and policymakers alike. However, the recent escalation of Middle East tensions hasn't had a "substantial impact on global growth or macro economic data," according to Deutsche Bank analysts.

"It's true that there are several channels whereby [Middle East tensions] could have an impact, such as via supply-chain disruption or higher energy prices, but so far at least, those haven't materialized to an extent that would have a meaningful effect on growth forecasts in other regions, such as the U.S. and Europe," Henry Allen, macro strategist at Deutsche Bank, said in a Monday client note.

Instead, China's massive monetary stimulus measures and a blockbuster U.S. jobs report have "outweighed" the geopolitical impact and pushed risk assets higher over the past two weeks. "Both events have shifted investors' assessment of the macroeconomic trajectory in a positive direction," Allen wrote.

Meanwhile, the rise in oil prices hasn't yet been to a level that would cause inflationary problems for the global economy. Brent crude for December delivery (BRNZ24) on Monday was up 3.7%, to settle at $80.93 a barrel on ICE Futures Europe, after posting its largest weekly climb in two years as tensions in the oil-rich Middle East continued to flare in the wake of Iran's missile attack on Israel last week.

With Monday's gains, the Brent oil contract was up for five consecutive sessions to post its largest five-day percentage gain since March 2022, according to Dow Jones Market Data.

Oil prices "remain broadly in line with their levels over the previous two years. After all, it was only in September that Brent crude closed beneath $70 per barrel the first time since December 2021, so the recent increase is coming from a low base," Allen noted.

See: From Pearl Harbor to Sept. 11, here's how stocks typically react to the outbreak of wars

What's more, Allen said geopolitical risk often has a smaller market impact than many imagine, in part because markets are always grappling with "inherent geopolitical uncertainty."

"There has never been a time when geopolitical risk isn't present. After all, in the decades of the Cold War there were regularly major tensions between the U.S. and the Soviet Union, so this is always something that markets are grappling with to some extent," the strategist wrote.

Geopolitics tend to have a bigger market impact when they trigger stagflation

History suggests that since World War II, geopolitical events have triggered a bigger selloff in the U.S. stock market when there was a simultaneous move toward the higher inflation and lower growth characteristic of stagflation.

See: The economy could be heading toward 1970s-style stagflation. What it means for the stock market.

To be sure, earlier this year, signs of stickier-than-expected inflation had some Wall Street strategists concerned that the economy could face a repeat of 1970s-like stagflation. In 1973, inflation surged into the double digits after a spike in oil prices fueled by the Arab oil embargo in the wake of the U.S.'s support of Israel in the Yom Kippur War. That was followed by another price rise at the decade's end, when the U.S. embargoed oil from Iran.

But that worry has fizzled out a bit after the Fed last month decided to cut interest rates for the first time in four years as annual inflation rate fell sharply in the third quarter of 2024.

However, some policymakers and economists also warned that the jumbo-sized 50-basis-point rate cut last month shouldn't be interpreted as an indication that the fight against inflation is over.

As MarketWatch reported, the recent Middle East tensions and the now-suspended U.S. port strike put inflation front and center again for the stock market - with investors worrying that a potential inflation resurgence could hinder the pace at which the Fed lowers policy rates and, more importantly, throw a wrench into the stock rally.

See: Stock market's soft-landing rally faces CPI inflation test. Here's what investors should do.

U.S. stocks finished lower on Monday as Treasury yields BX:TMUBMUSD10Y ticked higher. The Dow Jones Industrial Average DJIA was down nearly 400 points, or over 0.9%, while the S&P 500 SPX and the Nasdaq Composite COMP lost 1% and 1.2%, respectively, according to FactSet data.

See: What a 10-year Treasury yield above 4% says about the economy

-Isabel Wang

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10-07-24 1606ET

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