Iran conflict: Economic shock or sustained disruption?

Edited Q&A

When we last spoke, markets were trying to price in disruption. Since then, we've seen mounting evidence of damage to infrastructure, tightening physical supply, and even early signs of rationing. Has the narrative shifted from a temporary shock to something more enduring?

Callum: Yes, is the simple answer. I think it’s worth taking stock of some of the practical realities. The first is that ships take time to reach their destinations. For several weeks after the war started, consumers were able to continue benefiting from shipments that had set off before the war began, but the last of those are now arriving or have arrived.

There are some routes that avoid the Strait of Hormuz. Most notably, Saudi Arabia has a pipeline that runs across the country to a port in the Red Sea, with capacity to supply something like five million barrels per day by that route, which is a big chunk of Saudi net exports. There is a risk to that route as well, though, and this has been heightened in recent days by the Houthi rebels in Yemen, who have fired missiles towards Israel.

For now, at least, that hasn’t disrupted flows. So there is still Saudi supply reaching world markets via the Red Sea, and there are also some vessels continuing to pass through the Strait of Hormuz.

In a best-case scenario, if the war ended tomorrow and the Strait of Hormuz reopened, how quickly would things ramp up? The reality is that there is a mixture of relatively short-term damage and more significant damage that will require rebuilding, and we don’t yet know where that balance lies.

There would likely be a need for precautionary mine clearance and similar measures to ensure safe passage through the Strait. Then there is the time required to get ships into the right places to pick up cargoes, as well as the time taken to sail from the Gulf to destinations like China or Europe.

So even if the war stopped tomorrow, it would likely take several weeks, and possibly a couple of months, before supplies returning to consuming countries begin to resemble normal levels. And that is the best case, the pathway to that outcome remains unclear.

We also have Trump’s deadline of 6 April, which is on Monday. That is the deadline he has set Iran to reopen the Strait, otherwise the US may begin targeting Iranian energy infrastructure. That would very likely lead to retaliation against infrastructure in neighbouring Gulf countries.

It is not clear what progress negotiations are making. Trump has also suggested in recent days that the war could end within a week or two, with or without a deal. So even in the best case, we are looking at weeks of disruption, and it is not clear how close we are to that point. In essence, yes, the disruption is likely to continue for an extended period.

This war has lasted for over a month. Energy shocks don’t hit the economy all at once, they move in stages: fuel, then costs, then wages. Where are we now in that transmission process, and how close are we to second-round effects becoming a genuine concern?

Philip: In terms of the inflation process, we are right at the beginning.

Earlier in the week, we had so-called flash estimates of March inflation in the Eurozone, and those showed annual rates rising to 2.5% from 1.9%. That increase was entirely due to a near 7% monthly jump in energy prices. If you exclude energy, inflation actually edged back slightly.

As you say, the indirect effects come when goods and services providers attempt to pass their costs on to consumers. It is still very early days to get a clear view of that.

Finally, there is the risk that wages rise to compensate for higher prices. While that might not seem too problematic initially, it means firms then pass on higher wage costs in the form of higher prices. What begins as a one-off increase becomes ingrained inflation, which is costly to tackle and typically requires higher interest rates. That is what central banks are trying to guard against.

Equities have corrected, but not dramatically. Does this suggest resilience or complacency?

Clive: It is probably a bit of both. What often happens is that we tend to look at indices, but within an index there are very different dynamics at play.

Taking the UK as an example, there is a large energy component, and that is up around 25%. That could be interpreted as resilience, or simply a direct response to what has happened in energy markets. It also masks what has been happening elsewhere.

If you look at areas that have sold off significantly, such as housebuilders and airlines, they are down between 25% and 30%. In fact, within the FTSE 100, around 85 of the 100 stocks were down over the period.

So on the surface, the index may suggest complacency, but underneath there has been a broad sell-off, particularly in interest rate-sensitive sectors. So I would say there is no complacency, the strength in energy is simply masking broader weakness.

Energy markets tend to focus on benchmark prices like Brent, but the real stress is often visible elsewhere, jet fuel, diesel and physical cargoes. Are we underestimating the severity of the shock by looking at the wrong indicators?

Callum: Potentially. The price of Brent has, on several occasions in recent weeks, come close to $120 per barrel, which is clearly much higher than a few months ago. However, in historical terms, it is still below the 2008 peak of around $145.

There are also limitations to using Brent as an indicator. It reflects future delivery, and contract rollovers can distort price movements. For example, a recent apparent $20 fall included about $10 simply due to a change in contract.

More importantly, the price that end consumers are paying tells a different story. We have seen extremely high prices in products like jet fuel and diesel. Jet fuel has traded close to $250 per barrel at times, particularly in Europe and Asia, and diesel has been close to $200.

In physical crude markets as well, prices have been significantly higher than Brent would suggest. So yes, there is a risk that focusing solely on benchmark prices understates the severity of the shock.

How much are political constraints, such as fiscal costs, approval ratings and elections, shaping how long this conflict can realistically continue?

Philip: They are very important.

The estimated cost of US military action is around $2bn a day. While this is currently funded through the defence budget, that budget will eventually need to be replenished through Congress, where there may be obstacles given narrow Republican majorities.

There is also the electoral constraint, with midterm elections in November. Trump’s approval ratings have been negative for some time, around minus 17, and have deteriorated further since the crisis began.

At the same time, petrol prices in the US have risen to around $4 a gallon from $3 before the crisis. If there were to be significant US casualties, that would weigh heavily on public opinion.

Losing control of either chamber of Congress would limit the administration’s ability to govern, so there is clear pressure for a prompt end to the conflict.

If the conflict does not escalate dramatically but also doesn’t resolve quickly, what does that mean for UK and global growth over the next year?

Philip: The first impact is that short-term inflation prospects look worse. In the UK, fears of second-round effects are likely to prevent the Bank of England from cutting interest rates in the near term.

Energy prices are likely to remain above pre-conflict levels, even if the war ends soon, due to infrastructure damage and ongoing shipping concerns.

We expect UK inflation to remain elevated, with electricity and gas prices staying high over the summer, peaking at around 3.5 to 4% later in the year before easing.

On monetary policy, we expect rates to be held at 3.75%, with cuts coming next year.

In terms of growth, UK GDP is now forecast at 0.8%, around 0.5 percentage points lower than previously expected. Globally, growth is expected at around 3%, down from 3.3%.

So the impact is a modest downgrade to growth, though a more severe or prolonged conflict would have much larger consequences.

As we discussed, moves in equity markets suggest investors expect this to be short-lived. If that assumption proves wrong, where does the adjustment happen first?

Clive: If we start pricing in an extended energy crisis, the market has actually been incredibly efficient over the last month, so we would expect the areas that have been most negatively affected to continue to struggle.

That would include geographies that are particularly manufacturing-heavy and lack energy independence, such as Germany. We have also seen Japan come under pressure, and much of Asia more broadly, given how much of its energy supply originates from the Middle East.

As soon as you start seeing a global GDP slowdown and the risk of stagflation, deeper cyclicals come under pressure. We have already seen significant sell-offs in copper and mining stocks as a result.

So much of what we have already seen would likely continue.

Even traditional safe havens like gold and bonds haven’t behaved as expected. What does this tell us about the nature of the shock?

Clive: To understand gold’s response, you need to consider what it had already done prior to the Iranian crisis. Over the previous year, gold had risen around 80%, driven by a weaker dollar, expectations of falling interest rates, and strong central bank buying.

Since the crisis began, that backdrop has shifted. We have seen interest rates rise, the dollar strengthen, and expectations for rate cuts diminish. That has led to a sharp unwind, particularly given the number of leveraged positions.

So the gold response is less about the shock itself and more about the reversal of previous positioning.

If infrastructure damage across the Gulf were to escalate significantly, are we looking at a price shock or something more severe?

Callum: The worst-case scenario is widespread destruction of infrastructure. If that were to happen, it would lock in disruption for a prolonged period.

Inventories are limited and could only sustain supply for weeks or months. After that, prices would need to rise enough to force demand lower, potentially to levels seen during COVID.

If disruption continues for a few more weeks but begins to ease, does the oil market normalise quickly?

Callum: No, we are beyond the point of a quick normalisation. Even in a best-case scenario, it will take weeks or months for markets to stabilise.

What will tell you whether inflation risks are becoming entrenched?

Philip: The key indicator is wage growth. UK earnings are currently rising at just under 3.5%, which is broadly consistent with the inflation target.

A meaningful increase would signal risk, but the labour market is looser than in 2022, so we do not expect rate hikes, just a delay to cuts.

What signals would convince you that markets have fully priced this risk?

Clive: We are starting to see signs of stabilisation, bond yields, volatility and parts of equity markets are beginning to settle.

If energy prices stabilise, markets could recover relatively quickly. However, private credit remains an important unknown.

Finally, what matters most in energy markets right now?

Callum: Diplomacy is key.

Efforts by countries such as Saudi Arabia, Turkey, Egypt and Pakistan to de-escalate the situation are critical. Longer term, this crisis may accelerate the shift towards electrification and reduce reliance on oil.