Iran still a cloud for chastened world markets

By Gill Tudor, Investment Correspondent - Analysis

LONDON (Reuters) - In all the current market ructions, one of the initial reasons or excuses cited for the sell-off seems to have dropped off the screen -- Iran.

But investors could be in for a shock. Risk analysts say there could be an up to one-in-three chance that the United States or Israel will attack Iran by the end of this year, and markets may not be doing enough to hedge against the impact.

While a strike on Iran's nuclear facilities may still be far from likely, the surprise factor and worries about Iranian retaliation mean the market reaction could be far harsher than it was to the 2003 invasion of Iraq -- especially if investors' thirst for risk survives the current shakeout.

"We are entering this situation in financial markets in a rather more vulnerable state than we were in 2003 ... because people have loaded up on risk," said Mark Cliffe, global head of economics and strategy at ING.

"We expect sharp falls in stock markets, industrial raw materials, and in interest rates, and a huge widening in credit spreads," he told a round-table discussion on Friday. "We had a foretaste of that reaction this week but the important thing is that the magnitudes will be substantially greater."

Cliffe and Charles Robertson, ING's chief economist for emerging Europe, Middle East and Africa, co-authored a report in January called "Attacking Iran", assessing the market impact of a surprise Israeli strike on Iran's nuclear facilities.

They see huge initial turmoil, with subsequent moves hard to forecast as they would be driven by whatever happened next.

Although they put no exact figure on the probability of an attack by either Israel or the United States, and still say the immediate likelihood is low, they argue that President Bush might sanction some kind of military action before he leaves office late next year.

TIT-FOR-TAT ESCALATION

Several political risk consultancies take a similar view.

The United States, Israel and Iran all stepped up their rhetoric after Tehran ignored a February 21 U.N. deadline to halt uranium enrichment, and Washington has sent a second aircraft carrier to the Gulf.

Neither the United States nor Israel is likely to be planning an imminent attack, analysts say. Relative doves such as Secretary of State Condoleezza Rice seem to have the upper hand right now over hawkish Vice President Dick Cheney, and Washington has opened the door to talks with Iran over Iraq.

But the trigger for a U.S. strike could be more indirect. Washington accuses Tehran of arming militias attacking U.S. troops in Iraq, while Tehran accuses Washington of stirring violent sectarian and ethnic discontent in Iran.

A series of tit-for-tat incidents could escalate and tip the political balance in Washington, spilling into a strike on Iran's nuclear facilities.

"I do think the chances of that happening are one in three ... by the end of this year," said Heinrich Matthee, Iran analyst at London-based Control Risks.