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Fears of Israel-Iran escalation are driving stocks lower. Here is what investors need to know.

Cracks in the U.S. stock market’s big rally in the past five months intensified on Friday as investors worried about a potential escalation of tensions between Iran and Israel.

The Dow Jones Industrial Average fell for a fifth straight day on Friday, booking a 2.4% weekly loss, its biggest weekly decline since March 10, 2023, according  to Dow Jones Market Data.

The blue-chip equity gauge on Friday was less than 1% higher on the year so far, despite earlier in the year notching a string of record finishes.

Stocks already had been under pressure earlier in the week from fading expectations for significant Federal Reserve interest rate cuts this year when Friday’s rout struck, which was fueled by reports that Iran might be ready to attack Israel, pushing U.S. oil prices nearly to $86 a barrel.

“The stock market already rallied so much in a short period of time,” said Robert Pavlik, a senior portfolio manager at Dakota Wealth Management, in a phone interview with MarketWatch. “It came together in a perfect storm, with people starting to de-risk and take money off the table, not just in tech, but in other areas of the stock market.”

Wall Street’s “fear gauge” shot higher on Friday, with the Cboe Market Volatility Index closing 16.1% higher at $17.31, posting its biggest daily percentage gain since March 2023, according  to Dow Jones Market Data.

Looking ahead, it is possible escalation between Iran and Israel could cause the selloff in stocks to deepen, especially if energy prices continue to climb as a result.

Higher oil prices threaten to further dampen the Fed’s progress on getting inflation down to its 2% yearly target, with some energy experts warning of a return to $100 a barrel oil, if a conflict between Israel and Iran was to broaden and include other crude-producing nations. This could pressure the central bank to delay the rate cuts that it has been teasing since late last year.

“This could really put traders in a tough spot, because you have two countervailing worries,” said James St. Aubin, chief investment officer at Sierra Mutual Funds, during an interview with MarketWatch. “You have got geopolitics pushing against the Fed.”

But if history is any guide, there is reason to believe that any market impact would ultimately be temporary. Analysts have typically played down the influence that geopolitical developments can have on the stock market for one simple reason: even historic events like the Sept. 11, 2001, attacks in New York haven’t ultimately had much of an impact on corporate earnings, one of the most important inputs into equity valuations.

As a result, the selloffs they trigger are usually ephemeral, according to a team of strategists from Bank of America.

That being said, some analysts, including the team from Bank of America, see potential for a greater market blowback if tensions between Israel and Iran escalate into a full-blown war. The biggest threat to corporate earnings would likely stem from any disruptions to global trade that could occur as a result.

Plus, in addition to potentially forcing the Fed to be more cautious about cutting interest rates, rising energy prices could hurt European economies, which are more dependent on energy imports than the U.S.

However, the notion that this situation could escalate to that degree remains unlikely, St. Aubin said.

What’s more likely is that traders are losing sight of the fact that these public threats are probably part of a negotiation that is playing out largely behind the scenes, said Michael Lebowitz, portfolio manager at RIA Advisors, during an interview with MarketWatch.

“Like any negotiation, you’re trying to motivate the other side,” he said. “Both Israel and Iran are saber rattling, but neither one of them actually wants a direct confrontation.”


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