Weekly Winzer: Distraction

“As far as I’m concerned, it’s over,” said US President Donald Trump during a speech at the NATO summit in Ankara on Wednesday. He was referring to the existing ceasefire agreement between the US and Iran. He added that negotiations could continue, even though, in his opinion, that would be a complete waste of time. The financial markets reacted accordingly: The price of Brent crude rose to $78 per barrel, while stock and bond prices fell and the price of gold also declined.

Following the declaration of intent for a ceasefire a few weeks ago, the markets had reacted with relief. The prospect of a permanent reopening of the Strait of Hormuz created a positive mood, as this would, on the one hand, reduce stagflationary pressures and, on the other hand, lower the risk of an energy shortage and a sharp spike in energy prices (should the strait remain closed for too long).

Negotiations Remain the Only Option

It was clear from the outset that the negotiation process for a peace agreement would be bumpy and that there remains a residual risk of renewed escalation. There are advocates of a hard line on all sides (the US, Israel, and Iran). But what is the alternative to negotiations? Iran aspires to become a dominant power in the region, while other countries want to prevent that from happening. However, according to analyses, a military option without ground troops has only limited prospects for success.

Global growth and financial markets have proven resilient in recent years in the face of numerous negative developments (COVID-19, Ukraine, tariffs, Iran). In addition to supportive fiscal and monetary policies, this can be attributed to increasing investment in artificial intelligence (data centers, energy) as well as spending on defense and economic security.

Regarding the latter: The COVID-19 pandemic made it clear that efficiency (the cheaper, the better) should not be the sole determining factor. Resilient supply chains are just as important, although this also means higher costs. With the Iran crisis, the incentive has increased to diversify both energy sources (less crude oil) and supply chains (higher inventory levels of raw materials). These developments require higher investments.

Business environment remains favorable

From a purely economic perspective, the environment for high-risk asset classes has actually improved. The declining oil price has recently become another factor contributing to resilience. This had already led to falling inflation rates as early as June. Of course, the effects of the energy price shock will continue to be felt for some time to come.

But prior to the Middle East conflict, global economic growth was strong. Economic activity was somewhat dampened in the second quarter as a result of the oil price shock. Growth is expected to pick up slightly in the third quarter—as indicated by the latest data on global purchasing managers’ indices.

Inflation is likely to remain above the target

When it comes to inflation, it is important to distinguish between short-term and long-term trends. Inflation rates are currently falling because oil prices have dropped. The extent of the pass-through effects is uncertain. That said, there are some booming sectors that allow companies to pass on cost increases. A prominent smartphone manufacturer has already announced significant price increases due to rising semiconductor costs.

In the long run, inflation in many countries is unlikely to return to the central banks’ targets. This is due to the interplay between structural cost-driving forces and the policy response to them. The changing global order simply comes at a cost. This applies both to the fragmentation of the global economy (tariffs and resilience) and to rising defense spending. Added to this is demographic change. In this environment, fiscal policy is unlikely to be geared toward consolidation (lower budget deficits). Rising healthcare costs alone will ensure that this is the case. As a result of rising government debt-to-GDP ratios, governments will find it difficult to afford significantly positive real interest rates.

In other words: Despite the minimal increases in key interest rates currently taking place, key interest rates adjusted for inflation remain low. Monetary policy remains too accommodative. As a result, inflation is unlikely to return to the central banks’ target in the long run. The inflation target (usually around 2%) could be more of a lower bound than an average.

The environment for the financial markets can be described as one of “inflationary growth.” There may be a shift toward an “inflationary boom.” Barring any unexpected negative events (e.g., an oil price shock), the environment for risky asset classes will remain favorable.

 

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