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Energy stocks, gold and government bonds rallied after a U.S. airstrike in Iraq killed a high-ranking Iranian military leader on Thursday, as markets reflected concerns that the United States and Iran could be headed toward open conflict.

The Dow Jones Industrial Average sank as much as 368 points, or 1.3 per cent, on Friday morning before recovering some lost ground in afternoon trading. The index closed down 0.8 per cent.

The setback erased most of the gains from the previous day’s session, in which China’s announcement that it would loosen monetary policy to stimulate its economy had extended the remarkable rally of 2019.

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Now, investors appear to be recoiling from risk. Iran said it would avenge the death of Qassem Soleimani, one of the country’s most prominent military commanders, while the U.S. sent more troops to the region.

Markets also reacted to a disappointing report on U.S. factory activity on Friday, raising fresh worries about the health of the economy. The Institute for Supply Management manufacturing index contracted in December for the fifth consecutive month, falling to its lowest level since 2009.

Benchmark U.S. crude climbed $1.87, or 3.1 per cent, to settle at US$63.05 a barrel. It had been up 3.6 per cent earlier in the day. Brent crude, used to price international oils, rose 3.5 per cent.

“Oil prices … would likely rise much further if Iran retaliates, either by attacking Saudi oil facilities as it did in September, or attempting to block the Strait of Hormuz, through which 20 per cent of global oil supply is transported,” Michael Pearce, senior U.S. economist at Capital Economics, said in a note. “The latter could cause oil prices to spike as high as US$150 per barrel.”

He added, though, that the U.S. economy is relatively resilient when oil prices spike significantly, since the U.S. is no longer a net importer of oil products. As well, higher oil prices would boost domestic energy production.

The price of gold, a typical haven when geopolitical risks flare, rose to US$1,552.40 per ounce in New York, up 1.5 per cent.

Government bonds, another popular haven, also rose in price, sending yields lower. The yield on the 10-year U.S. Treasury bond fell to 1.813 per cent, down 6.4 basis points (a percentage point has 100 basis points).

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Rising energy stocks and gold miners helped to limit losses in the commodity-heavy S&P/TSX Composite Index, which fell just 0.2 per cent.

Share prices for Canadian Natural Resources Ltd. rose 0.8 per cent and Barrick Gold Corp. rose 0.5 per cent, offsetting declines by economically sensitive banks, railways, auto-parts manufacturers and airlines. Air Canada stock fell 3.4 per cent and Magna International Inc. fell 2.4 per cent.

Among U.S. companies, defense stocks rallied in anticipation of conflict: Northrop Grumman Corp. rose 5.4 per cent and Lockheed Martin Corp. rose 3.6 per cent. However, Bank of America Corp. fell 2 per cent and Amazon.com Inc. fell 1.3 per cent.

Some observers expect that rising oil prices will falter, given that there is plenty of oil to satisfy the current demands of the global economy.

“If the situation worsened, and oil supplies were disrupted, this could have broader economic and financial market impacts through a sharp rise in crude oil prices,” Mark Haefele, global chief investment officer at UBS, said in a note. “However, spare capacity in oil remains adequate.”

The gain in the price of oil comes amid renewed focus on the widening gap – or differential – between U.S. oil and Western Canadian Select oil (WCS), the heavy crude produced in the oil sands that has been trading at substantially less than the U.S. benchmark, West Texas Intermediate, and depressing the Canadian energy sector.

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On Friday, that gap widened to US$23.40 a barrel, according to Bloomberg data, the biggest in a year. But that’s still less than half the differential seen in October, 2018, before Alberta took measures to address swelling inventories of crude trapped in the province, which within weeks narrowed the gap to as little as US$7.

The recent widening in the differential is a result of Canadian inventory levels rising, aggravated by a temporary outage in the Keystone pipeline that affected output into November, and the recent strike by workers at Canadian National Railway Co., according to analysts at AltaCorp Capital.

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