FOCUS NOTE THE CRISIS IN THE MIDDLE EAST CRISIS MERGES REGIONAL AND LOCAL RIVALRIES SUMMARY PICTET WEALTH MANAGEMENT 5 JANUARY 2017

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1 SUMMARY The Middle East is in the throes of a long conflict pitting Saudi Arabia and its Sunni allies against Iran and its Shiite allies. During Barack Obama s second mandate, this became interlinked with a New Cold War between Russia and the West, creating one of the world s most dangerous geopolitical situations at present. Pascal de Crousaz, PhD International Relations Head of Private Banking Israel and Turkey SAUDI AND IRANIAN RIVALRY HAS DEEP ROOTS Saudi Arabia and Iran have long been rivals for regional pre-eminence. At stake in Syria is the emergence of a Shia crescent stretching from the Persian Gulf to the Mediterranean. Russia, meanwhile, is seeking to reassert its power. TRUMP S ELECTION COULD RESHAPE ALLIANCES Donald Trump s election as US president has cast US policy in the Middle East into question. The US could find itself on the side of the Moscow-Damascus- Tehran axis in Syria, with far-reaching implications. However, there are major obstacles to a US rapprochement with Russia, and a contradiction in Trump s hardline stance on Iran. GEOPOLITICAL INSTABILITY IN THE REGION WILL REMAIN HIGH We expect geopolitical instability in the Middle East to remain high in Developments may be for the worse, for instance, with an aggravation of the tensions between Riyadh and Teheran, or for the better, perhaps with Iran and Saudi Arabia reaching some kind of modus vivendi after six years of crisis. BRENT AND WTI CRUDE OIL PRICES, Brent WTI 8/06/2016: WTI 51.2$ +96% since min % since end $/b. 31/12/2015 WTI: 37.1$ 20 11/02/2016: 26.2$ Thomson Reuters, ICIS Pricing, Datastream MACROECONOMY GEOPOLITICS CENTRAL BANKS ASSET ALLOCATION ASSET CLASSES WEALTH MANAGEMENT INVESTMENT CONCLUSIONS Tensions in the Middle East tend to affect financial markets through the oil price. We expect prices broadly to stabilise in 2017, averaging around USD55/b. However, geopolitical shocks in the region will continue to affect the oil price and create tremors on financial markets. It is important to ensure that portfolios are protected against such shocks where necessary. 1 OF 6

2 INTRODUCTION Since the turn of the second decade of the 21st century (starting from around 2008 to 2011), factors of instability on the international relations front have increased worldwide. In this paper we are concerned with the conflict in the Middle East that pits Saudi Arabia and its Sunni allies against Iran and its Shiite allies. Superimposed on this pole of tension is another: the resurgence in recent years of a muted confrontation between Russia and the US, creating one of the world s most dangerous geopolitical situations at present. This geopolitical tension has had a strong impact on financial markets, via the oil price, and is likely to remain a major exogenous factor for markets over the coming years, for both good and bad. This is especially the case since, with a new administration moving into the White House, the foreign policy of the world s leading superpower is currently subject to considerable uncertainty. To understand how geopolitics can so readily permeate financial markets, we will first look to history to explain why the Middle East has become a hotbed of complex historical, geopolitical and economic tensions, both local and global. We will then explore the potential impact of these tensions on the markets and the oil price. UNDERSTANDING THE SITUATION: HISTORICAL BACKGROUND Iran and Saudi Arabia are two leading regional powerhouses with no shortage of reasons to be rivals. First, there is the ageold divide of Islam between Sunni and Shia, dating back to Muhammad s death in 632. The Shia claimed leadership of the Islamic community for Muhammad s descendants by way of his cousin and sonin-law, Ali. Their followers, known as the party of Ali (Shi at Ali), were eventually ousted from mainstream Islam after Ali s son, Hussein, was martyred in 680. The Shia then remained a marginalised minority for centuries, even to the point of persecution at times. This all changed in 1501 when Shah Ismail of the new Safavid Dynasty declared Shiism the state religion of Iran, giving the Shia a powerful patron. Iran and Saudi Arabia are two leading regional powerhouses with no shortage of reasons to be rivals In the mid-18th century, a Muslim preacher and scholar in the Arabian desert condemned what he saw as a decline in Muslim powers and called for a return to the values and behaviours of the first Muslims (the pious ancestors, or al-salaf el-salih, hence the term Salafist). This preacher, Muhammad ibn Abd al-wahhab, began an alliance with the Saud family, the tribal rulers of the Nejd region. In 1802 the Wahhabi- Saudi state sacked the Shiite holy city of Karbala, including the tomb of Hussein. At the beginning of the 20th century the Saudis captured Riyadh, and their subsequent expansion brought all of Arabia under their control. In 1932, Abdul Aziz Ibn Saud proclaimed the Kingdom of Saudi Arabia. As the Protector of the Two Holy Cities, Saudi Arabia considers itself the leader of the Sunni Arab world, or even the entire Muslim world. Oil was discovered in the Saudi desert in With oil reserves too large to avoid unwanted attention, but a population too small to defend them, Abdul Aziz Ibn Saud struck a deal with US President Franklin D. Roosevelt in 1945 on board the USS Quincy, whereby the Americans would defend the Saudi kingdom and dynasty in exchange for secure access to reasonably priced oil to fuel their economic growth. The oil concessions granted under the Quincy Pact were for a period of 60 years, subsequently renewed in 2005 for the same period by President George W. Bush. As oil prices shot up over the years, Iran and Saudi Arabia enjoyed handsome revenues, and became rivals for regional dominance. US Secretary of State Henry Kissinger managed to neutralise the rivalry by aligning the two conservative monarchies on the same side against the Soviet Union and its allies. This alliance fell apart, however, when the Shah of Iran was overthrown by the Islamic Revolution in The rivalry became total hostility: Iran is now a revolutionary Islamic republic and vehemently anti-american, while Saudi Arabia remains a conservative monarchy and a US ally. The Iranian revolution presented a triple threat to Saudi Arabia: First, Iranian revolutionaries called for an Islamic revolution throughout the Muslim world and challenged the Saudis for international leadership of Muslim nations. Also, leaders of the Iranian revolution pledged to protect the Shiite minorities in Sunni-ruled countries. As it happens, Saudi Arabia s Shiite minority makes up the majority of the population in the kingdom s oil-richest province. Saudi Arabia feared an Iran-backed bid for secession. Finally, the Iranian hardliners made no secret of their desire to overthrow the corrupt monarchs of the oil-producing Gulf powers, subservient to the American Great Satan. 2 OF 6

3 Luckily for the Gulf monarchies, they were buffered from the Iranian threat for a quarter of a century by an anti-iranian dictator who brutally suppressed the Shiite majority of Iraq: Saddam Hussein. So when the Americans toppled Saddam Hussein in 2003, they also broke the defensive line separating Iran and Saudi Arabia. The new situation did not immediately place the Saudis at risk: US military forces were still deployed and, in any case, Iran was severely weakened since 2003 by international sanctions imposed over its nuclear programme. However, this all changed with the formation of a pro-iranian government in Baghdad and the withdrawal of US forces in By intervening in Iraq in 2003 to establish a parliamentary democracy, the Americans had in effect handed over the country to the Shiite majority, who for centuries had been denied political power. Before withdrawing from Iraq, the Americans did all they could to prevent the democratic government in Baghdad from becoming a dictatorship of the (Shiite) majority. However, shortly after the last US forces left Iraq in December 2011, Iraqi Prime Minister Nouri al-maliki chose to play the Shiite card, alienating the country s minorities. He also sought closer ties with Iran. When the Americans toppled Saddam Hussein, they broke the defensive line separating Iran and Saudi Arabia. In 2012, talks on Iran s nuclear programme began under the aegis of the permanent members of the UN Security Council and Germany. These talks would culminate in the lifting of UN sanctions, giving Iran the financial clout and international legitimacy it sought. The Sunni monarchies of the Gulf were left facing a Shia crescent stretching from the Persian Gulf to the Mediterranean, across Shiite Iran, Iraq under Shiite domination, Syria under Alawite control, and a Hezbollah-dominated Lebanon. Iranian power seemed to be rising inexorably. Iranian power has appeared to be rising inexorably Moreover, the Obama administration was showing signs of disengagement in the Middle East, viewing the Asia-Pacific region as the main geopolitical theatre of the 21st century. The expansion of shale oil and gas production since 2009 also made the US less dependent on Middle East oil. The interdependency implicit in the Quincy Pact seemed diminished can Saudi Arabia and its dynasty still count on the US for their defence? N Cairo Ankara Mediterranean Lebanon Sea Israel Palestinian territories Libya Egypt Sudan Khartoum Turkey Aleppo Syria Damascus Amman Jordan Red Sea Baghdad Iraq Riyadh Saudi Arabia Sanaa HOW THESE TENSIONS HAVE CRYSTALLISED TODAY A few days after NATO launched its intervention in Libya in March 2011, protests against the Assad regime gained huge momentum in Syria. For the first few months, the civil protests in Syria were peaceful. In the summer of 2011, however, officers who refused to give the order to shoot civilians defected and formed the Free Syrian Army (FSA). From that point, the crisis rapidly assumed a regional dimension. Since the late 1960s, Syria has been ruled by the Assad family with the backing of fellow Alawites, a Muslim sect that emerged from an 11th-century schism. Although the regime is Alawite, and a close ally of Iran since the early-1980s, the majority of Syria s population are Sunni. The Syrian insurgency was thus welcomed by the region s Sunni elites, who had been largely impotent in the face of Shiite Iran s rise. Yemen Baku Caspian Sea Tehran Kuwait Iran Bahrain Qatar Turkmenistan Ashgabat United Arab Emirates Muscat Oman Afghanistan Arabian Sea Pakistan Kabul 3 OF 6

4 The Saudis and their allies were determined to halt their arch-rival Iran, and this meant targeting the Achilles heel of the Shiite axis: the Assad regime. If President Bashar al-assad were to be overthrown and replaced by a Sunni regime, this would break up the Shiite axis. For Saudi Arabia and Iran, Damascus became the key to Middle East supremacy. And the city of Aleppo, part of which came under rebel control in 2012, is considered the main gateway to the capital. Moreover, the severing of the Syrian link would cut off Iran and its Shiite brethren from the Hezbollah in Lebanon, potentially giving Lebanese Sunnis an opportunity to regain control of the country. The Saudis, Qatar and also Turkey under President Recep Tayyip Erdogan sent funds and weapons shipments to support Syrian rebels both moderates and radical jihadists. Meanwhile, Iran came to the aid of the regime in Damascus with funds, weapons and military advisers. The Hezbollah in Lebanon, an ally of Iran, sent contingents to support President Assad s forces. The Saudis and their allies targeted the Achilles heel of the Shiite axis: the Assad regime By June 2015, however, the Syrian regime appeared to be in serious difficulty against an Islamist militia coalition backed by Saudi Arabia and Turkey to the west and Islamic State (IS) to the east. Iran dispatched Major General Qasem Soleimani, commander of the elite Quds Force of the Iranian Revolutionary Guards, to prevent the fall of its ally, President Assad. Another ally of the Assad regime was also ready to intervene: Russia. The Assad regime was a close ally of Moscow during the Cold War, and Syria still hosted Russian naval facilities. Vladimir Putin has sought to reassert Russia s power on the international stage Since his first presidential term in the early-2000s, Vladimir Putin has sought to restore the power of state institutions, reinforce his position as Head of State and reassert Russia s power on the international stage. The Russian President denounced support from the Bush and Obama administrations and their European allies in the democratic revolutions in Eastern Europe (mainly Ukraine) and the Arab World (the Arab Spring ) as outside interference in the domestic affairs of sovereign states that, one day, could possibly threaten Russia itself. He also accused NATO of seeking to expand its military reach and warned that, in any case, regime-changes only led to chaos. The Kremlin regretted not having vetoed Libya s humanitarian intervention at the UN Security Council, equating to Russia s de facto support for a regime-change. For that reason, it was determined to thwart any such future operations. Putin had already fought a brief war against Georgia in 2008, and then in 2014, following a pro-west revolution in Ukraine, Russia annexed Crimea and backed a separatist insurrection in the Donbass region Eastern Europe, however, presents only limited opportunities to assert Russia s regained power. As most countries there are now NATO members, any attempt to strike would automatically trigger a military response from alliance members. However, another region slightly further afield seems to offer a more promising playground with much less risk of escalation: the Middle East. Or more specifically, the epicentre of the crisis: Syria. In July 2015, Soleimani flew to Moscow to flesh out his strategy to save the Assad regime: a massive joint intervention, with Iran and Shiite militias on the ground and Russia striking from the air, to definitively put the rebels in check. The rebels backed by Sunni states found themselves cornered in a decisive battle for Aleppo. Strained relations between Russia and the West have echoes of the Cold War The reassertion of Russia s position in Eastern Europe and the Middle East has greatly heightened tensions with the West. Russian Prime Minister Dmitry Medvedev said in February 2016 that the strained relationship between his country and the West could be described as a new Cold War. Meanwhile, Germany s Foreign Minister said in October that mounting tensions and suspicions were even more dangerous than during the Cold War. WHAT NEXT? THE IMPACT OF THE US ELECTIONS AND THE UPCOMING FRENCH PRESIDENTIAL ELECTION The election of Donald Trump to the White House this autumn has raised many questions about the future foreign policy of the world s leading power. Some of his campaign pledges, if followed through, would fundamentally undermine the strategic balance of power in several parts 4 OF 6

5 of the world, spurring political volatility that would undoubtedly spill over into the financial markets. One of the constants in Trump s presidential campaign was his high regard for Putin. Apart from his admiration for Moscow s strongman, Trump also pledged on the campaign trail to broker a deal with Russia. Could this be a new version of Yalta, at the end of the Second World War, when the global powers divided the Old World into zones of influence? The President-elect s decision to offer the role of National Security Advisor to Michael Flynn and the office of Secretary of State to Rex Tillerson, both of whom have been openly in favour of better relations with Russia, signals a departure from policy on Russia under both George W. Bush and Barack Obama. Still, the path of US policy under the next administration remains largely unknown. The US could find itself on the side of the Moscow-Damascus-Tehran axis ing implications for Eastern Europe and the Middle East. Specifically in the Middle East, if the US partnered with Russia, agreeing to intervene only to defeat IS, the US President would theoretically have to revise his alliances. The US would find itself on the side of the Moscow-Damascus-Tehran axis, becoming a de facto defender of Assad and having to abandon its support for moderate Syrian rebels and their allies, particularly Saudi Arabia. Since mid-2014, the more tensions rise in the Middle East, the more the oil price falls In the fight for regional supremacy, this would spell victory for the Shiite camp in the Syrian civil war, i.e. for Iran. And yet, throughout his candidacy, Trump repeatedly referred to Iran s mullah regime as a threat to America and pledged to revise the Iran nuclear deal. At this stage, it is too early to say how this contradiction can be resolved. WHAT THIS MEANS FOR THE MARKETS Since mid-2014, there has been a reversal of the general trend since the Second World War: now, the more tensions rise in the Middle East, the more the oil price falls. With their open-tap policy, Saudi Arabia and its allies deliberately triggered a 70% oil-price drop between July 2014 and January Their main objective was to protect their market share. With the world s lowest production costs, the Saudis could afford a price war to drive American shale producers from the market. The US had increased oil production so much in previous years that, at certain times in 2014, it even overtook Saudi Arabia as the world s biggest producer. Another rival targeted was Russia, which had recommissioned some THE WORLD S LEADING OIL PRODUCERS (BARRELS/DAY IN MILLIONS, 3Q 2016) 14 Regarding the 2017 presidential election in France another country with huge ge- 12 opolitical stakes in the Middle East the 10 nomination as centre-right candidate (and likely victor, in our view) of François Fillon, 8 who openly welcomes Russia s role on the international stage in general, and in Syria 6 in particular, increases the likelihood of rearranged objectives and alliances seeking a 4 rapprochement with Moscow. 2 POSSIBLE SCENARIOS FOR THE MIDDLE EAST A partnership between Russia and the US (or even France) would have far-reach- 0 US Russia Saudi Arabia Canada Iraq China Iran UAE Kuwait Brazil Source: Pictet WM-AA&MR, International Energy Agency, Nov OF 6

6 Soviet-era capacity and pushed its production to new records. At the same time, Riyadh was eager to protect its market share in anticipation of Iran stepping up production once sanctions were lifted. There was also a political dimension to the Saudis price policy: low oil prices for Iran and Russia would weaken their ability to defend the Assad regime in Syria. Moreover, they believed the more Saudi Arabia consolidated its fundamental position on the oil market, the more likely the US would be to honour the Quincy Pact. We expect oil prices to average around USD55/b in 2017 Traditionally the oil price has been inversely correlated with the price of risky assets, particularly equities. All things being equal, a substantial rise in oil prices generally led to losses on the equity markets, which factored in the recessionary impact of high energy prices on industrial economies. Similarly, lower oil prices translated into equity market gains. From the second half of 2015 onwards, this correlation switched to positive: the more the geopolitical tensions rose and oil prices fell, the greater the losses on risky assets. At the end of January and early February 2016, when tensions in Syria were at their highest and the Russian PM warned of the risk of a third World War over Syria, the oil price and equity markets slumped to their lowest levels. From March until the Brexit vote in June, a ceasefire in Syria was followed by an uptick in oil prices, which also spurred a recovery in equity markets. While there were obviously other factors involved, i.e. of a purely economic or financial nature, the geopolitical situation was undoubtedly a major factor in events on the financial markets. Oil currently seems to have reached its fair value at around USD50 per barrel for Brent crude. We expect prices to average around USD55/b in 2017, while supply continues to adapt to sluggish demand. The agreement between OPEC members on 30 November and with non-opec producers a week later should reinforce this trend, as long as participants comply. Saudi Arabia agreed to a higher production quota for its rival Iran while accepting to curb its own output an act of appeasement between two countries whose leaders could barely have conceived of such an idea just weeks before. Also, given the negative correlation in place since last year, a geopolitical détente in the Middle East will bring stable or higher crude prices. Russia also agreed to curtail output. Whether such an agreement stands the test of time remains to be seen. However, due to underinvestment in the oil industry over the past two years, we are unlikely to see a massive oversupply except in the event of a global economic crisis and a lastingly lower oil price environment. Overall, oil prices at this level will boost the stock markets, enabling energy earnings to continue their rebound without overburdening broader economic growth. There is, in any case, an upper price limit beyond which unconventional hydrocarbon producers are ready to return en masse, particularly US shale drillers, who can resume production at relatively short notice. The Middle East will continue to be a major source of geopolitical upsets Nonetheless, we expect geopolitical instability to remain high in Saudi Arabia and its partners may not be prepared to stand by and watch their allies suffer defeat, as seems to be happening in Syria. This, together with various unknowns of the incoming US administration s policy on geopolitical hotbeds, will sustain a degree of uncertainty and risk surrounding oil prices and financial market volatility. The Middle East will continue to be a major potential source of such upsets whether for the worse, with a deterioration of the Syrian crisis, or for the better, with Iran and Saudi Arabia reaching some kind of modus vivendi after six years of crisis. Notice: This document is not intended for persons who are citizens of, domiciled or resident in, or entities registered in a country or a jurisdiction in which its distribution, publication, provision or use would violate current laws and regulations. The information and data contained in this document are provided for information purposes only; the Pictet Group is not liable for them nor do they constitute an offer, an invitation to buy, sell or subscribe to securities or other financial instruments. Furthermore, the information, opinions and estimates in this document reflect an evaluation as of the date of initial publication and may be changed without notice. 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