In this note we summarise the questions we have received from our clients and the responses we have given, following the assassination of Major General Qassim Soleimani, the leader of the Quds Force of the Islamic Revolutionary Guards Corps of Iran, in a US drone attack in Iraq on 3 January. The key points we have been making are as follows.
War – A wholesale attack on Iran (our definition of an all-out-war) is no more likely now than before the Soleimani assassination. Although it is an unprecedented escalation, the arguments against an all-out war still stand.
Iran's response – The overnight rocket attack on two airbases in Iraq where US forces are based, is in line with the type of response that might have been expected, but we can only guess if there will be further actions taken. The rhetoric of Iran's leadership is no better a predictor of its action than the rhetoric of US President Trump is a predictor of US action. Iran has already been escalating its proxy military activity in the region for over a year (in an effort to counter the US policy of "maximum pressure", splinter the potential coalition the US might corral, particularly in the GCC, and force a concession on sanctions). The goal of Iran remains sanctions relief, not to bog the US down in a war (that is arguably of more interest to Russia).
Oil – We see greatest risk of disruption to federal Iraq output and exports (not the Kurdistan Region of Iraq directly, although destabilisation or distraction of the federal government would impact KRI via delayed federal budget disbursement). Iran exports are already constrained. Only in a scenario where the Iranian leadership has nothing to lose is there a risk of spillover of a conflict from, potentially, Iraq to the GCC.
Iraq – Iraq is a more likely location than Iran itself for limited kinetic military action between US and Iranian aligned forces (because of the presence of US forces, the client-sponsor nature of the relationship between the Iraqi Shia political elite, following the fall of Saddam, and the Iranian government, and Iraq's position as the most important of Iran's external allies). The threat of economic sanctions on Iraq by the US, and the missile attacks by Iran on US military assets in Iraq, are consistent with this argument.
Iran leadership and regime – The Iranian leadership and government is very unlikely to implode politically from within (economic hardship and popular protests do not outweigh the monopoly on the tools of violence, internal unity and pact with the religious clerics enjoyed by the Islamic Revolutionary Guards Corps).
MENA equity investment case – Overall, we are still relatively unenthusiastic about regional equities (particularly compared with the Asian markets we cover), with our top picks still Dubai (cheap albeit with low growth), Egypt (cheap albeit with FX rate and long-term growth risks) and Saudi consumer and construction (driven by social liberalisation and public spending, albeit not compellingly cheap).
Frequently asked questions (and my responses) on Iran
(1) Does Soleimani assassination make war with Iran more likely and, indeed, is it not an act of war?
We admit the Soleimani assassination is an unprecedented escalation and, arguably, a de facto act of war.
But the arguments against an all-out war still apply, for example:
- The formidable difficulty of invasion and occupation (surgical airstrikes alone are likely insufficient to provoke the sort of change in behaviour that Iran's opponents would wish to see and the US electorate likely lacks the appetite for another mass deployment of troops overseas).
- The likely immediate regional and global spread of this conflict (e.g. Russia and China are far more assertive today than they were, for example, at the time of the second Iraq War in 2003).
- The challenge for the US to corral a broad coalition (i.e. beyond Israel, including the EU, Turkey and a unified GCC).
- The less combative foreign policies of Saudi (following the Aramco attacks) and Abu Dhabi (following the achievement of its aims in the Yemen war).
See Iran: Major escalation yes, all out war no, 3 January 2019.
(2) Does the Iranian leadership have to respond for its own domestic credibility and to preserve the stability of its own regime? Alternatively, might this action actually push Iran to pursue the path of negotiation with the US?
The goal of Iran remains sanctions relief, not to bog the US down in a war (which, arguably, may be of more interest to Russia).
Iran's rhetoric is no better a predictor of its action than the rhetoric of US President Trump is a predictor of US action. The overnight rocket attack by Iran on two Iraqi airbases where US forces are based, is the type of response that might have been expected, but we can only guess if there will be further actions taken. Javad Zarif, Iran’s foreign minister, tweeted after the attacks that ‘we do not seek escalation of war, but will defend ourselves against any aggression’. The context is that Iran has already been escalating its proxy military activity in the region for over a year (in an effort to counter the US policy of "maximum pressure", splinter the potential coalition the US might corral, particularly in the GCC, and force a concession on sanctions).
The Iranian leadership and government is very unlikely to implode politically from within (economic hardship and popular protests do not outweigh the monopoly on the tools of violence, internal unity and pact with the religious clerics enjoyed by the Islamic Revolutionary Guard Corps).
The example of Zimbabwe demonstrates that if the armed faction of the leadership monopolises all the tools of violence, then popular protest is not a sufficient cause for change (revolution) in the political system and if that armed faction has no alternative refuge (i.e. the Iranian Revolutionary Guard cannot simply retire to its barracks) then it will always prioritise political survival over economic performance (sanctions, implosion of economic output, currency and public services).
Escalated conflict reinforces the supremacy of hardline, "principilist" conservatives (compared to reformist, "pragmatic" conservatives like President Rouhani and Foreign Minister Zarif) and we expect evidence of this in the upcoming 21st February legislative elections. Presidential elections are not due until 2021. The tilt towards the hardliners (which dates back to the US Congress inhibiting some of the trade benefits envisaged from the Nuclear Deal and accelerating following US President Trump's reneging on the deal in May 2018) is particularly important given a potential succession looms at the apex of the political structure (Supreme Leader Khamanei is aged 80).
(3) Why is the Iraq political elite shifting to a policy of pushing out US troops when Daesh remains a threat? Why does the Iraq government's response suggest they are closer to Iran than the US? Would regional and global powers be drawn into a proxy US-Iran conflict in Iraq?
Although US-led forces dismantled the Saddam regime over the course of the two Iraq Wars, the subsequent occupation and reconstruction has resulted in neither a fully independent sovereign entity with a stable democracy and an effective government, nor a client state of the US. Instead, Iraq can be more accurately described as a client state of Iran. This represents a stark reversal from the Iran-Iraq war of the 1980s when Saddam was funded by states which now comprise the GCC and armed by the US.
Following the fall of Saddam and disbandment of his Sunni Arab-dominated armed forces, the government of Iraq has been dominated by the Shia political elite (the 60% of the population made up of Arab Shia drives the Shia majority in the elected parliament) and the mainly Shia armed Popular Mobilisation Units. But the Shia spectrum in Iraq is highly fragmented (both in terms of parliamentary political parties and armed militias), bound only by sectarian identity (suspicion of both the Sunni Arabs and Kurdish ethnic groups) and its reliance on Iranian sponsorship.
The client-sponsor relationship between Iraqi politicians and the Iranian government is more important to those politicians than Daesh or, arguably, responding to the complaints of the local population. As soon as sections of the recent popular protests in Iraq morphed from focusing on the chronic under-delivery of public services by the government to the opposition to Iranian influence, they were met with an armed response.
This explains the speed with which Iraq's parliament is trying to push for a dis-invitation to US troops (most recently invited to assist in the fight against Daesh).
From an Iranian perspective, Iraq is arguably the most strategic of all its external spheres of influence because of a number of factors, mainly centred around Iraq's neighbouring location:
- A desire to avoid any repeat of the brutal Iran-Iraq war of the 1980s, an era which an Iranian at or below the median age of 32 has no recollection of but one which legitimised the current political supremacy of the Revolutionary Guard and shaped its foreign policy).
- Iraq is the start of the transit route (Iraq, Syria, Lebanon) to the Mediterranean Sea and the EU for gas exports, which Iran would wish to establish in the long-term.
- The presence of US military assets and personnel.
- The presence of the remnants of Daesh (currently subdued by a coalition of all regional forces but where Iran argues its coordination of ground troops was the most important component).
- Iraq's oil reserves (equivalent to about 65% of those in Iran and mainly in areas dominated by the Shia population).
If there is going to be kinetic military action between the US and Iran (and its proxies), we regard Iraq as a more likely arena than Iran itself or the likes of Syria or Lebanon. This compounds the existing disruptive risks in Iraq (re-emergence of Daesh, popular protests, fragmented Shia political elite and resulting governmental paralysis).
We think that in the event of a limited US-Iranian conflict in Iraq, regional powers (e.g. the GCC, Israel, Turkey, Pakistan) and global powers (China, Russia) can more easily avoid being drawn in compared to an all-out war in Iran itself. A conflict concentrated in Iraq could be viewed as one between two rivals which demonstrably enjoy more power and influence than the sovereign government of that country – the same could not be said for an invasion of Iran.
(4) Is the US being rational (i.e. does it understand the consequences of this action)?
Reaction of US President Trump vs Iran Foreign Minister Javad Zarif to overnight Iraqi airbase attack. Source: Twitter
The explanation for the assassination of Soleimani, that assumes rationality on the part of the US, is that after a year of Iranian escalation (e.g. tanker attacks, Aramco attacks, shooting down of a US drone and most recently the death of one US contractor and the one-day siege of the US embassy in Bagdad) it serves the US strategic goal (maximum pressure on Iran with minimum military deployment) to serve up a reminder of its willingness to flex its military muscles. In this interpretation, the US figures that Iran also does not want to engage in all-out war, and therefore, like Iran it is seeking to establish a credible (but unpredictable) threat of destructive military action in order to establish the strongest position in a new round of negotiation. For the US domestic electorate, and specifically an important segment of President Trump's support base for re-election, the highly personalised nature of this action resonates.
In many respects, because the US is not willing to commit military resources on the scale required for an all-out war, but still needs to project a credible threat, then one way to do that is to project irrationality: rational irrationality if you like. Ironically, this is exactly how we used to interpret Iranian rhetoric and action from the time of President Ahmadinejad until the Obama-Rouhani detente: if you are visibly less committed or less competitive in a military fight then project maximum irrationality and unpredictability.
Explanations that assume rationality on the part of the US strike us as more plausible than those that rely on the characterisation of President Trump as a non-strategic actor (whether completely unconstrained by his military or, depending on the crudeness of the critic, suffering from character flaws ranging from ill-informed to egotistical to unhinged). Explanations reliant on these supposed attributes tend to emanate most often from his domestic political rivals and international geopolitical opponents (both of whom tend to focus on his rhetoric and the inconsistencies in that rhetoric, as opposed to treating his rhetoric as one component of his actions).
(5) Does the Soleimani assassination significantly raise risks in Saudi and the UAE? How does this affect the peripheral parts of the region, e.g. Egypt, Pakistan, Turkey?
Iran has already demonstrated capability and resilience in five respects:
- Withstand economic pressure from sanctions.
- Harm economic assets of global oil customers (the oil tanker attacks).
- Harm economic assets of Saudi (the Aramco attacks).
- Support aligned governments in the wider region (Afghanistan, Lebanon, and Syria).
- Establish closer relations than it has historically enjoyed with countries such as China, Russia and Turkey.
It has also maintained diplomatic dialogue with powers traditionally aligned very closely with the US (e.g. France and Japan).
All of this has arguably made it much harder for the US to amass the sort of coalition it did in the first Iraq War in 1990.
Only in a scenario where the Iranian leadership has nothing to lose do we see a sawn-off shotgun approach to destabilising the wider region to a greater degree than it is already doing. That scenario would only materialise should there be an all-out war (i.e. sustained air strikes and, potentially, a ground invasion).
We realise there is a circularity in this argument: we do not believe Iran will be attacked in an all-out fashion, therefore we do not think Iran will lash out in an all-out fashion. Absent this scenario, we regard Iran's main goal as seeking relief from sanctions. That involves balancing its credible threat to regional security with keeping the door open to negotiation with the US. Iran's prospects of entering those negotiations are stronger the more the US has to shoulder the burden of projecting a credible military threat against Iran. If Iran pushes its regional proxies too far then it risks broadening the coalition prepared to rally behind the US. The successful, surgical Aramco attacks are best understood in this context: enough to demonstrate high capability with no civilian casualties (and plausible deniability to boot).
(6) Does the current focus of US foreign policy on Iran create space for more aggressive actions by anti-US governments and militants elsewhere?
We very much doubt that the escalation of US-Iran friction provides more room for governments with foreign policy goals which may conflict with the US (e.g. China, Russia or, to a lesser degree, Turkey) or non-state militants with anti-US goals (e.g. the Taliban in Afghanistan, Al Shabab in Somalia, or the plethora of Al Qaeda and Islamic State affiliates in the Sahel region of Africa) to pursue their goals. This would be more likely if the US was to divert significant military resources away from the regions of interest to these countries and non-state actors and, instead, to Iran.
The greater space for manoeuvre for US rivals exists, in the first instance, because the US no longer has the appetite for large-scale overseas military deployments and has been walking back from its singular superpower role since before the Trump electoral pledge to end the endless wars. It was under the Obama administration that, for example, focus shifted from global policing to the pivot East, long-standing allies in the Middle East were abandoned during the "Arab Spring", and Al Assad's crossing of the chemical weapons red-line in Syria was effectively tolerated.
The escalation in tensions with Iran (which should still fall short of an all-out war) does not alter the fact that the US is no longer the singular superpower, it a reflection of that fact.
(7) Why are you and other locally-based analysts and observers so sanguine on the geopolitical risks: this is surely an unprecedented escalation which means we cannot simply expect more of the same?
Put simply, we have been here before; not specifically with an assassination of an Iranian general outside his country's border but in terms of major periods of uncertainty and risk in many countries in the region.
For much of the last century (going back to at least the break-up of the Ottoman Empire and the Sykes-Picot agreement of 1916) the Middle East has been characterised by tension, protests, succession uncertainty, proxy conflict, inter-state war, and external interference. This pre-dates the development of the regional oil industry.
In the last decade alone there have been periods of heightened geopolitical risk (e.g. the bellicose rhetoric of the President Ahmadinejad, the fall of long-standing leaders in the "Arab Spring", the civil war in Syria, the emergence of Daesh in Iraq and Syria, the Qatar embargo, the Yemen war).
Of course, the region is underperforming relative to its economic potential because of intra-regional tension, conflict and trade fragmentation, but that does not make it uninvestable at the right valuation. If anything, we think investors have been too complacent over the past year during the escalation of tensions with Iran (particularly following the Aramco attacks) and the Soleimani assassination is perhaps finally breaking that complacency. But that does not mean consensus should suddenly shift to expecting an all-out war with Iran.
To some degree, we have also been here before in the more recent experience of the Trump administration: a recurring feature of the style with which foreign policy is conducted is that the most shocking rhetoric and, occasionally the most shocking action, is followed by a move towards detente or dialogue. The conduct of relations with, for example, China, North Korea, Pakistan, Russia and Saudi have, at different times, followed this pattern. We admit though that it is hard to find a US action with these countries that is as shocking as the Soleimani assassination,
(8) Where does all of this leave the investment case in MENA on a standalone basis and relative to the rest of the frontier and emerging market universe?
Overall, we are still relatively unenthusiastic about regional equities (particularly compared with the Asian markets we cover), with our top picks still Dubai (cheap albeit with low growth), Egypt (cheap albeit with FX rate and long-term growth risks) and Saudi consumer and construction (driven by social liberalisation and public spending, albeit not compellingly cheap).
A full-blown war with Iran could prove such a conflagration that investments will be the least of anyone's worries. More plausible worst-case scenarios (e.g. a hot war in Iraq alone) would obviously make for greater risk for all of the Middle East, but arguably geopolitical risk was already ratcheted up following the oil tanker and Aramco attacks and the region has been through highly disruptive but very localised conflicts before (the civil wars in Lebanon, Syria, Yemen and Libya, the second Gulf War). However, two factors are different this time:
(i) although oil-exporting sovereigns in the region enjoy a fiscal benefit from higher oil price, they are also under pressure to restrain output (as a part of OPEC Plus commitments) and local high-net-worth capital is generally more flighty than in previous eras.
(ii) the impact of foreign (instinctively more skittish, obviously particularly in the passive funds segment) investors is far greater following the inclusion of Kuwait, Qatar, Saudi, and the UAE in the MSCI EM Equity index and the GCC sovereign US$ bonds in the JPM Global EM Bond index).
Where there are equity markets valued well below 5-year median PB or PE we see few catalysts (Dubai, Jordan, Oman), or very poor policy frameworks (Lebanon, Turkey). The exception is Egypt (although it has its own challenges in terms of retaining foreign debt portfolio capital as interest rates plummet and avoiding FX rate pressure in the short-term, and creating jobs long-term). Elsewhere, equity markets are either valued close to their historic average (Abu Dhabi, Qatar, Saudi) or significant premiums which may have little support once index reclassification-related flows subside in Q2 20 (Bahrain, Kuwait).
Potential beneficiaries of higher oil prices are Colombia, Kazakhstan and Nigeria (although Colombia and Nigeria have their own material security risks).
We see the best combination of growth and value in the Asian markets in our coverage (and although a higher oil price is unhelpful for this region, except for Vietnam and Malaysia, the pressure on current accounts should be manageable as long as the oil price remains below roughly US$80).