Weekly Winzer: Outlier risk

Last week, the ceasefire in the Iran war was extended indefinitely. On the one hand, this reduces the risk of a resumption of hostilities and further escalation, which could further damage the private energy infrastructure in the Gulf region, among other things. Nevertheless, the economy and financial markets are still exposed to a considerable outlier risk.

In our baseline scenario, the stagflationary impulse of the Iran conflict is noticeable, but not so strong that the favorable environment of “inflationary growth” is overturned. Before the rise in energy prices, global growth was above potential, while inflation rates were above the central bank’s target of 2%. Nevertheless, the risk of an abrupt transition to an environment of high inflation and shrinking economic output should not be underestimated.

No alternative to negotiations

There is effectively no alternative to negotiations between Iran and the USA. A military solution does not appear to be expedient. A prolonged blockade of the Strait of Hormuz would not only cause massive damage to Iran itself, but would also entail the risk of a global economic crisis. The question is therefore not whether serious negotiations will begin, but when. Time is of the essence. Accordingly, the pressure from other states – such as China or other Asian countries – on both parties to the conflict to find a compromise is likely to increase.

The longer the Strait of Hormuz remains closed, the greater the risk of a further surge in energy prices and concrete energy shortages. At some point, stocks will be exhausted and the currently priced-in expectations of an imminent fall in energy prices will no longer be tenable. In other words, the longer the standoff between the US and Iran continues, the higher the risk of a recession.

Bottlenecks pose greatest threat to global economy

This is not primarily about the level of energy prices. The greatest risk to the economy comes from potential energy bottlenecks. In most cases, economic activity cannot simply be shifted to other available forms of energy (e.g. by quickly switching to solar power), nor can it be quickly switched to less energy-intensive production processes. Often, the only option is to reduce economic activity itself – for example by reducing production or driving less on fossil fuels.

An additional sharp rise in energy prices increases the risk of recession, as consumers and companies have less financial leeway for other expenditure. A forced fall in demand due to a real energy shortage would be even more serious – this would have a much stronger and more direct impact on the economy.

So far, however, the economic indicators have been robust. The price indicators – both the survey-based and consumer price indices – have risen significantly, but not to any great extent. Growth indicators, such as the preliminary purchasing managers’ indices for April, have also proved to be resilient, at least on the surface.

Central banks struggle for credibility

In their management of market expectations, the central banks have used recent statements to focus more on the inflation risk and less on the labor market risk, thereby adopting a hawkish stance. As a result, market expectations for future key interest rates have risen. For example, the European Central Bank is pricing in a key interest rate hike from 2% to 2.5% by the end of 2026.

Numerous important central bank meetings are taking place this week. No concrete interest rate moves are expected from the US Fed, the European Central Bank or the central banks in the UK and Canada. Nevertheless, inflation rates have already been above the central bank target for five years. As a result, the credibility of central banks’ ability to keep inflation under control in the long term is increasingly at stake.

 

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