What the Markets Are Telling Us About the War in the Gulf

Investors started last week confident that the Israeli-U.S. attack on Iran would be another short war they could all but ignore. The S&P 500 even rose slightly on Monday.

They ended the week worried that a global shock to oil prices from what’s become a widespread Middle East conflagration is in some ways a repeat of 2022’s Russia invasion of Ukraine and threatens stagflation.

The investment question now is whether signs of worry are a reason to buy the dip, or a reason to get out before things get even worse.

Start with the comparison to Russia’s disastrous attack on Ukraine. Oil prices spiked to $120 a barrel from $90 before the assault as investors priced in disruption to supply. They are still only at $91 today. But in percentage terms, the rise is the same as in 2022, just from a lower level. The oil market is seriously spooked.

Stocks outside the U.S. are also reacting as they did when Russian tanks started rolling. MSCI’s index of global ex-U.S. stocks is down 6.6% from its high before the Iran bombing started, about in line with the 2022 move.

After that, the parallel breaks down. There has been no flight to the safety of bonds, gold or currencies such as the Swiss franc that usually act as havens in a crisis.

“We don’t have the geographical proximity to make this feel as scary from a human perspective,” said Jacob Manoukian, U.S. head of investment strategy for J.P. Morgan private bank. “But markets are starting to realize that there’s a probability that this starts to leak into the economy.”

Explaining the moves of the week—and so preparing for what comes next—involves more than just investors’ interpretation of how Iranian drones or White House rhetoric will feed through into oil prices.

There were two big effects. Economically, sudden higher oil prices create a shift in the winners and losers. Energy exporters outside the Middle East benefit and importers suffer. Financially, the sudden volatility made investors hunker down and reduce their debts.

More expensive oil is bad for Europe, Japan and Korea, all big importers. It is actually a net benefit to the U.S., as an exporter and the world’s biggest producer. The attack on Iran and its retaliation against the oil infrastructure and shipping route of neighbors hurts the biggest global competitors to U.S. oil producers, at least temporarily.

This is the simplest way to understand why the dollar rose while the euro and yen tumbled, and why U.S. stocks were hurt less than those overseas.

Financially, assets that had gone up a lot this year fell the most, and some of those that had been big losers actually went up, despite markets overall struggling.

This was true at the country level, where the biggest winners—led by Korean stocks, up 50% before the war started thanks to massive buying on margin—fell the most. This was followed by the next biggest, Japan, then the U.K. and Europe. U.S. stocks were barely up before the war began, and barely fell as it progressed.

It was also true within the market. Software stocks fell hard this year on fears of competition from artificial intelligence, while chip makers soared. In the past week, software stocks actually rose, while semiconductor stocks fell sharply.

Almost half the Nasdaq-100 index rose, and all but nine of those had been down for the year before the war. Knowing how much Nasdaq stocks moved this year up to the war explains 60% of moves in the past week based on a regression analysis. Unlike with the countries, it is hard to discern an economic logic that could trigger such a winners-become-losers dynamic.

Further evidence comes from Goldman Sachs’s index of stocks popular with hedge funds, which fell much more than the market, down 4.7% over the week. Its index of hedge funds’ biggest shorts dropped just 1.1%, half as much as the S&P. This is what we should expect as hedge funds close out positions to cut back their borrowing, but the moves aren’t big enough to suggest panicked deleveraging.

This sets up a template for what could happen if the war drags on and oil prices rise much more. Deleveraging would keep dragging down the hottest areas for a while. Eventually, proper panic would set in, at which point demand for safety would almost certainly overwhelm concern about inflation and push down Treasury yields.

At some point between now and then, history suggests investors should buy the dip. Legendary banker Nathan Mayer Rothschild probably never said to “buy when there’s blood in the streets,” but it neatly captures the idea that investors often panic when there’s a war on.

The trouble is to know when, which means watching for the initial signs of market chaos getting even worse—and knowing yourself. If you buy too early, will you sell again as losses build, and so miss the eventual bounce? When the market is truly swimming in red, will you actually have the guts to buy? Get ready.

Write to James Mackintosh at james.mackintosh@wsj.com