Will Israel-Gaza war sink stocks and shake the global economy? Watch oil prices.

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Wall Street on Monday shook off a bout of selling sparked by the Israel-Gaza war.

That’s in keeping with the historical tendency of investors to look past geopolitical conflict and human tragedy, but it isn’t necessarily the last word. That last word will likely belong to oil traders.

“Oil rallied today yet remains below the near-term peak from last month. If oil prices rise higher for longer, the global economy could feel a resurgence of inflation during a period when investors are hoping inflation is clearly decelerating,” said Jeffrey Roach, chief economist for LPL Financial, in emailed comments.

Roach also noted that, in general, markets tend to have difficulty pricing the difference between a temporary shock and a permanent shock.

For now, however, the jump in oil prices isn’t signaling a permanent shock. Sure, Brent crude
the global benchmark, jumped 4.2% on Monday to end at $88.15 a barrel, while West Texas Intermediate crude

surged $3.59, or 4.3% to $86.38 a barrel — the biggest one-day jump for both grades since April 3.

See: Here’s what Israel-Gaza war means for oil prices as fighting continues

The jump was impressive, but it comes after a big pullback last week that saw both WTI and Brent retreat from 2023 highs near $100 a barrel.

So if crude can manage to close above those highs — $93.68 a barrel for WTI — investors across other markets will likely take notice.

Oil futures were pulling back modestly early Tuesday, with Brent and WTI each down 0.4%.

What would it take to drive crude back toward the highs? The focus is on Iran.

The Wall Street Journal on Sunday reported that Iranian security officials helped plan the attack by Hamas. The Israeli military has said there is no concrete evidence of Iranian involvement, according to news reports.

A direct role by Iran, a longtime ally of Hamas, would raise the threat of a broader conflict.

Some analysts have put Iranian crude production at more than 3 million barrels a day and exports above 2 million barrels a day — the highest levels since the Trump administration pulled the U.S. out of the Iranian nuclear accord in 2018, according to the Wall Street Journal. Sales fell to around 400,000 barrels a day in 2020 as the U.S. reimposed sanctions.

“If Israel discovers that Iran played a role in Hamas’ attack, it could retaliate militarily. At the very least, any warming of relations between Iran and the West is now on hold and this will limit incremental oil supply,” said Nicholas Colas, co-founder of DataTrek Research, in a Monday note.

It’s a reminder that “while neither Israel nor Gaza are major oil producers, everything that happens geopolitically in the Middle East invariably ends up affecting oil prices,” he said.

The potential for a broader conflict could lead to a “sharp market correction,” argued Olivier d’Assier, head of applied research, APAC, at Axioma.

The scale of the conflict, the largest since the Yom Kippur War 50 years ago, renders comparisons with how markets have shaken off past geopolitical incidents, but they may be irrelevant in terms of stress testing, he argued.

“The closest historical scenarios we could use would be 9/11 and the start of the Ukraine war. But because both took place on Western soil, they might not be adequate,” d’Assier said.

On Monday, however, remarks by Federal Reserve officials ultimately trumped the rise in crude prices and jitters over the Middle East. Dallas Fed President Lorie Logan and Fed Vice Chair Philip Jefferson both noted the rise in long-term Treasury yields and their role in tightening financial conditions, which investors took as a signal the Fed may not be as likely to further raise interest rates.

See: An Israel-Hamas war could change what the Fed does about interest rates

Stocks turned north after a morning dip, with the Dow Jones Industrial Average
rising nearly 200 points, or 0.6%, while the S&P 500
also advanced 0.6% and the Nasdaq Composite
gained 0.4%.

For now, market participants appear set to look ahead to economic data later this week, including September consumer-price index and producer-price index readings.

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