The Middle East Conflict – After effects and consequences for India

On the American television show “The Apprentice” co-produced and hosted by Donald Trump, his favourite line was “You’re fired”. The show became very popular and ran for 15 seasons. Donald Trump hosted 14 of them. Mr. Trump seems stuck in his role of the host and can’t get enough of the firing. In his second term, through DOGE he was keen on reducing bureaucratic cholesterol by “firing people”. Then he went international and started “firing tariffs” at countries with whom the US had (or didn’t have) trade deficits, defying the laws of economics and international relations. Then he fired at Venezuela and Greenland. But old habits die hard. I understand that. And so, it seems Mr. Trump has focused his attention on Iran. This time it is not the firing of people or tariffs or blurs but missiles. With the help of ever ready Israel. It seems his theatrics are getting bolder and bolder as he realizes that after every mischief the tempo tapers and he has to come up with a bigger version to be taken seriously. I will write about the method behind his madness (if any) in some other post. Today, I want to contemplate what would be the effects and consequences of Mr. Trump’s latest mischief on India.

To be or not to be

The perennial question that has amused humanity (after Who Am I) has confronted India since the outbreak of this war. India has maintained good relations with IRAN and Israel. We have vibrant trade with both countries. IRAN’s proximity with Pakistan, its hold on Port of Hormuz and its potential geographic importance for a possible trade corridor through Chahbar port is crucial to India. On the other hand, Israel (proxy of US) is a powerful actor in the Middle East. India feels Israel is a good counterweight against terrorism in West Asia and stands beside her in the war against terrorism. It is important for India to maintain good relations with Israel to counterweight China-IRAN relations and be on the side of strongest ally of the US. Till now India has neither supported nor condemned the strikes on IRAN and maintained a diplomatic neutrality, calling for de-escalation. IRAN’s attacks on its neighboring countries did not sit well with India. Currently, India’s primary concern is its diaspora of around 9 million people in countries that are being attacked by IRAN. In the medium term it can affect their livelihood and their ability to remit close to 80 billion dollars home. US & Israel’s prolonged attacks can keep oil prices elevated, putting India’s fiscal deficit under pressure. India has problems that are completely out of her control and the answer to this perennial question, to be with or not to be with Israel (or IRAN), seems to be elusive, till now. Strategic autonomy has its costs.

Macro, micro and markets

To start with, let me distinguish between what we know and what we don’t know.

Known – Unknowns

• How long will the conflict go on and more importantly from an Indian perspective how long will Strait of Hormuz remain closed
• Will IRAN escalate further on GULF countries and their energy infrastructure
• After the latest red line of 48 hours declared by POTUS, will there be the 9^th red line declared, effectively, diminishing the idea of red lines
• Will FED intervene in the financial markets to calm investors, if bond yields spike
• What is and would be the role of China. If the US wants to control the choke point of oil via Strait of Hormuz, will China retaliate by invading Taiwan, controlling the choke point of semi-conductors

Known – Knowns

• Strait of Hormuz is closed for more than 20 days, and it will be increasingly difficult for India to bring down the cost of its energy basket if this escalates
• There seems to be no mediation between IRAN and the US (Israel) as of now. Both parties have denied engaging in negotiations through diplomacy
• Nifty has corrected by more than 8% and Rupee is at record low levels
• Current oil shock has not converted into a crisis, but we see small South-East Asian countries have started taking measures to preserve energy.

Crude oil is India’s Achilles’ heel. We are heavily dependent on crude oil imports for our energy needs. Whenever crude goes up substantially it affects our current account and inflation negatively. Higher current account deficit puts undue pressure on the rupee. Higher crude prices and depreciating rupee mean higher inflation and eventually higher interest rates. India can withstand temporary shock, but if the problem persists, real GDP growth could be affected in the coming quarters.

Crude oil and its derivatives are one of the most important raw materials used as inputs in various industries. Higher prices will affect the margins of these industries putting pressure on their profits. Current EBITDA margins of BSE 500 companies (ex-financials) are around 16%, whereas that of BSE Small Cap 250 (ex-financials) are around 11%. This oil shock could affect margins by up to 2%. Larger companies will be able to absorb better than smaller ones. If the government decides to pass on higher crude prices to consumers this will not only affect consumer price inflation directly, it will also hurt overall consumer spending, slowing aggregate demand.

Coming to markets. Nifty has already corrected by 8% and Indian VIX (volatility index) has remained above 20 since the outbreak of the war. VIX above 20 means markets are expecting higher than normal volatility in the coming 30 days. This index needs to be watched from the sentiment perspective. On the fundamental side, markets are re-pricing assets “on the go”. Let me explain. Value of every Asset has 2 parts. One is the steady state value a.k.a the terminal value. The question we ask while determining terminal value is, will this asset generate cash flows for the next 5, 10, 15 years? So, if we feel that India will survive and grow beyond this crisis along with the world, terminal value is not affected much. Second part of the value equation is growth (near term & medium term). If markets sense sluggish growth in the near term, they will re-price assets lower. 8% plus correction in NIFTY reflects the near-term growth concerns. Markets will react based on new information (on the go). These are also the times when markets may overreact and start discounting growth “and” terminal value, offering them at a discount.

What should investors do?

First, acknowledge that outcome of the war and by extension closure of Strait of Hormuz is uncertain. We don’t know. Things may de-escalate before you finish reading this note, or I may have to write a follow up a few weeks later. This makes investing based on “breaking” news difficult. It would be better if we shifted our focus on fundamentals. Valuations are good. There has been a time correction of more than 1.5 years and with recent price correction, it is safe to assume that money invested today with a horizon of 3 years and above should beat bonds easily. This is comforting. Investors who are building new portfolios can deploy anywhere between 30 to 50 percent of capital today and wait for some time to see if there is more correction. Investors who are looking to add to their existing portfolios should add at least 20 percent if they can. If liquidity is not available, it will be prudent to wait for some more time and re-adjust your portfolio to more aggressive positions. Investing aside, war brings tremendous hardships to people who lack resources and puts immense pressure on governments. A prolonged war ends by sowing seeds for the next one. Let’s hope this ends soon. Not for the markets, but for the people who are caught in the midst of this madness for no fault of their own.