The geopolitical situation in the Middle East has continued to escalate in recent days. US President Donald Trump did emphasise that the USA and Iran were communicating “directly and indirectly” and expressed confidence that the new Iranian leadership would act “reasonably”. However, in an interview, Trump also openly stated that the United States could “take the oil in Iran” and was considering occupying Kharg Island, Iran’s most important oil export terminal.
At the same time, the Houthi militias from Yemen have officially joined the conflict, and the USA has deployed naval units to the region. This suggests that the United States is preparing for a military operation against Kharg Island or measures to control the Strait of Hormuz or is at least threatening to do so.
Stagflationary impulse
The potential implications of the war for the economy and the financial markets are well known, as they are reminiscent of patterns seen in previous energy crises:
- Rising energy prices and disruptions to global supply chains
- Increasing inflationary pressure
- Restrictive central bank policy and rising interest rates
- Falling real income and subdued demand
- Slowdown in global growth
- Tightening financial conditions (rising interest rates, falling share prices, widening spreads, higher risk premiums in emerging markets).
Extent of the shock unknown
Whilst the mechanism behind stagflation is well understood, the duration and scale of the shock remain highly uncertain. What is certain, however, is that the forces on energy prices have intensified since the start of the war, and with them the knock-on effects.
The key risk now lies in further escalation. Should the Strait of Hormuz be blocked for an extended period of time, or should civilian infrastructure come under increased attack – ranging from oil and gas terminals and chemical plants to power generation, data centres, and desalination plants – energy and commodity prices could rise significantly once again. The repercussions would extend far beyond oil and gas, affecting, for example, fertilisers or specialised industrial raw materials such as helium.
Falling market prices
The reaction of the market since the outbreak of the war has followed the classic pattern of an energy price shock. Prices for crude oil and natural gas, and for commodities derived from them, have increased, whereas both bond and share prices have fallen. The price of gold has also fallen significantly. The expectations of future price volatility priced into the equity market have risen sharply.
Falling economic indicators and rising inflation
The first economic indicators for March have now been published, revealing the impact of the war on the economy. The preliminary Purchasing Managers’ Indices for industrialised nations have fallen significantly overall, as have the German Business Climate Index and consumer confidence in the United States. At the same time, the sub-indicators for inflation contained in the reports (corporate purchase and sales prices, consumer inflation expectations) have risen. The flash estimates for consumer price inflation published for Spain and Germany also show sharp increases.
Revised forecasts
Last week, the OECD became the first multilateral organisation to issue an assessment of the impact of the energy price shock. The economic growth forecast remains resilient (for now). However, the inflation forecast has been revised significantly upwards.
For the Eurozone, the growth forecast was lowered by 0.4 percentage points to 0.8%. Meanwhile, the inflation forecast was raised by 0.7 percentage points to 2.6%. The macroeconomic impact is therefore noticeable, but not yet overwhelming.
Note: Prognoses are not a reliable indicator of future performance.
Central banks between a rock and a hard place
Central banks face a classic dilemma: should they raise key-lending rates to curb the spill-over to sectors outside the energy sector and dampen second-round effects (higher wage increases)? Or should they ease their monetary policy to mitigate the economic slowdown?
In many countries, inflation has now been above the central bank’s 2% target for around five years. Most central banks have therefore – at least in their rhetoric – opted for the first option. For example, in numerous statements, some central bankers have advocated for a focus on low inflation. That is the case because a further energy price shock increases the risk of a renewed wave of inflation, which would undermine the credibility of central banks to ensure low inflation in the medium term.
Consequently, a revaluation took place on the interest rate markets. For example, the European Central Bank is expected to raise its key-lending rate by 0.76 percentage points by the end of the year (currently: 2%). For the US Federal Reserve, the interest rate cuts previously priced in have disappeared. In summary, the energy price shock is forcing central banks to adopt a restrictive – and thus growth-dampening – stance.
The role potential negotiations could play
At least in the short term, Iran’s negotiating position appears to be stronger than the USA and Israel had anticipated. The reasons for this are clear: the fallout from the war is more painful for the USA (higher energy prices and falling share prices). Also, Iran still retains control over the vital Strait of Hormuz.
There are arguments in favour of official direct or indirect negotiations between the USA and Iran: the risk of military escalation, potentially involving the deployment of ground troops; the potential spread of the conflict to other countries; and the Iranian regime’s interest in political survival.
On the other hand, Iran appears to be speculating on its ability to retain control of the most important lever – namely, control of the Strait of Hormuz. Added to this is the low popularity of war in the USA, Congress’s reluctance to provide funding, and the high political costs of a possible ground deployment.
If negotiations were indeed to take place officially, the markets could react with relief in the short term: falling oil prices and risk premiums, rising share prices. However, should said negotiations fail or military operations escalate even more – particularly around Kharg Island or the Strait of Hormuz – further market turmoil would be conceivable. One key argument for the failure of negotiations is that Iran might believe it could lose the war militarily but win the energy war.
Portfolio management: focus on risk management
As early as in mid-March, we reduced the equity portion in our portfolios to below the strategic target allocation and shifted more funds into safe-haven money market instruments. We also reduced the proportion of gold in favour of the money market, as several central banks in emerging markets are selling off gold reserves to stabilise their currencies.
In an interview, the President of the European Central Bank outlined three guiding principles for tackling the crisis.
1. Assess the nature, scale, and duration of the crisis.
2. Focus on the risk rather than just the base-case scenario.
3. Have a range of response options ready.
These principles are not only applicable to monetary policy – but also to the management of a robust portfolio in the current climate.
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