Update: The Middle East conflict and the global economy

Edited Q&A

We’ve been seeing wildly fluctuating prices in the oil market and even a surge above that psychologically important $100 per barrel mark. To what extent is this price behaviour a reflection of genuine supply disruption, versus a market trying to price geopolitical uncertainty?

Callum: Well, there is genuine disruption. Something like 20% of world supply is currently unavailable because of the war, which is absolutely unprecedented, certainly in a very long time.

And I think even if the war were to stop tomorrow, the degree of disruption to logistics, damage to infrastructure, and inventories that have been drawn down to make up for supply shortfalls, mean that it would be very difficult for the market to snap back to where it was in early February.

On the other hand, if the war continues for an extended period – many more weeks or possibly even months – at some point we have to face the reality that the demand for oil is going to have to be cut back so that it’s in line with actual supply. Cutting back demand by 20% would need levels of mobility and business activity like what we saw during COVID. I think that gives us an idea of just how serious this problem is and how much more serious it could become.

If you think about what sort of price oil would need to be to disincentivise that amount of demand, it’s probably very much higher than we’ve already seen. We did see nearly $120 per barrel briefly on Brent, but it may need to go a lot higher than that. At the moment, the market is trying to work out where on this spectrum we are going to end up. Is the war going to end relatively soon because of the pressures that it’s creating, or is it going to go on for an extended period? And it’s very hard, of course, for the market to know, which is why things are so volatile.

Geopolitical shocks don’t always translate into economic shocks because markets sometimes absorb them quite quickly. Looking at this conflict as it stands, what damage has already been done to the global economy?

Philip: Clearly this is a geopolitical shock that is material, where you’ve had something like a 40% surge in oil prices in dollar terms since the attacks on Iran began, and spot natural gas prices have close to doubled. While it’s still relatively early days, you can see the negative impact on confidence in the economy beginning to creep in from some early surveys.

Longevity of the shock is critical. So, if energy prices were to remain at current levels for too much longer, it would have an impact on, for example, corporate investment decisions, and it would also hurt consumer spending, as if a household pays for more energy, it has less money to spend on other items.

One redeeming factor, at least in the Northern Hemisphere economies, is that we’re coming up to spring now. In other words, the peak expenditure period on heating is behind us. Another point is that we shouldn’t just assume that this is going to be a longstanding conflict or energy price shock.

Investment markets have remained relatively composed so far. Why do you think the response has been restrained? Do you think the suggests that investors may see the disruption as temporary?

Chris: I think that’s spot on and we can see it in a number of different metrics. For example, if you look at the copper price, copper would typically give a good steer for what investors think about the global economy, and typically, it’d be quite sensitive. And in an environment where you expect weaker growth, you would expect the copper price to come down. And it’s barely moved since this conflict kicked off.

And if you look at equities, equities are down, but they’re only down by a couple of percent. It does seem to be the case that markets are pricing in that the oil shortages will be very short-lived and from a market perspective, that does present an asymmetry if it is the case.

In the best-case scenario, this ends quite soon and we’re able to rebuild the inventories and oil prices come down quite quickly. That seems to be in the price. But if it does persist a bit longer – and that’s a non-negligible possibility – then it does suggest that there is some downside ahead.

If the conflict though continues into the weeks or even the months ahead, where are the first risks likely to emerge in financial markets?

Chris: We’ve seen some of it already. Prior to the conflict for some central banks across the globe, there was a possibility that they were going to be cutting [interest rates] this year, and those possibilities were priced into the market. Think of the US as an example: the market was looking at about two rate cuts. If we look at South Africa, the market was looking at about one to two, and already those have been ruled out.

If this persists, I think we’ll start to see inflation expectations shift up. And if it shifts up significantly, we’ll start to see rate hikes priced in. And then we are in a different ballpark. At that point, you have to start to question the growth outlook for the global economy, and with that, any earnings expectations. I think that would have a greater impact on markets than we’ve seen so far.

Do you think markets then are underestimating the economic risks of this conflict?

Philip: I think you could argue that at least in some markets, if you look at equities, we've had something like a 3-4% retracement in the S&P500, which is basically saying no lasting damage to corporate earnings is expected. And I’d have to reinforce that by saying that US stocks were expensive anyway, and this episode hasn't been used as an excuse for a major repricing, so arguably, stock markets are quite sanguine.

If you look at interest rates and bond markets however, I’d say that they show a different picture. In the States, they are pointing to perhaps a 0.25% cut by the Fed this year, but they’re expecting 1.5% interest rate increases from the ECB before the end of 2026, and roughly a 50% chance of one increase by the Bank of England, as well.

I think we would say that this is probably pricing in too much bad news i.e. too much high inflation.

The International Energy Agency has already announced a 400-million-barrel reserve release, with the conflict showing no clear end. Does this meaningfully stabilise the markets?

Callum: The maths of this are relatively straightforward. We’ve got a supply disruption of something like 20% of the world supply, so around 20 million barrels per day. So, this reserve release is equivalent to about 20 days worth of the current disruption, and the war has been going on for nearly 20 days. This means the reserve release replaces the barrels that have so far been disrupted. Obviously it helps, but it isn’t a solution. And if the war continues much longer, then this will clearly not be enough.

The other problem is, even if the war does end relatively quickly, inventory has been released. And of course, once you've released that inventory, your inventories are then lower. So, the ability to deal with any further disruptions, perhaps if the war started up again or whatever, would be reduced. And so the market needs to price for that, potentially with an ongoing risk premium.

Some analysts suggest the bigger risk now is potential damage to Gulf oil infrastructure. How might that play out in oil markets, do you think?

Callum: It’s pretty difficult to assess exactly how much damage has happened and, and how long it might take to repair, but I think it’s worth noting that in 2019 when there was a drone strike on a Saudi production processing plant, which took offline about 50% of Saudi production, it was restored to nearly full capacity in about a couple of weeks. So, it depends on the extent of the damage.

Now, if something is destroyed completely it would be a serious problem. There have been suggestions from the Americans in recent days that they might have destroyed the oil terminal on Karg Island, which is the main source of output for all of the Iranian production in terms of how it accesses world markets. It would take a very long time to replace that. But so far, we haven’t had anything on that scale. So, a lot of actions are precautionary in shutting things down.

When oil prices spike sharply, economists often ask whether it could push the global economy towards stagflation. How quickly do energy shocks like this feed into global inflation?

Philip: That’s a good question. It takes time to get absorbed fully. The initial impact is on petrol prices, and many consumers in the UK are saying that happens too quickly, i.e. petrol companies are profiteering. But after that, what you begin to see is a gradual pass through from, for example, manufacturing and services providers who have major engine inputs, and whose costs have increase.

The danger is that it then passes through to higher pay settlements. In turn, that would give firms another reason for another round of price increases and what you see is the risk permanently higher inflation. And it means that central banks have to lean against it quite hard, with higher interest rates, and that’s where you get a stagflation risk, or at least you get higher inflation and a lower growth environment.

From a portfolio perspective, where do investors typically find resilience during energy shocks?

Chris: If there’s a sizable shock, most risk assets would sell off. Even something like gold often doesn't provide protection at the start of a problem like this. The only protection you can typically get in an environment like this is cash. And the problem there is, if this does persist and it leads to higher inflation, cash is not particularly helpful. You’ll lose money in real terms.

Over the medium term you require hard assets. Equities do provide protection against inflation, but it is over the long run.

If the conflict were to drag on for another few weeks without meaningful deescalation, what would begin to change materially from a macroeconomic perspective?

Philip: If we’re talking about the conflict lasting a number of weeks, that’s probably a relatively benign outturn. Now, it might take time for oil supply to get back fully on stream, and we may not see $65, $70 a barrel oil prices for a while longer, but under those circumstances, it’s still reasonable to expect a visible decline in prices. So, what you then see is inflation rising for a while, but then it comes down as oil prices ease back as well.

And perhaps, what you get as a response from various central banks is that they hold off from cutting rates for a while longer, but those easings in policy do take place later on in the year. And what you don’t get, is a series of rate increases to stave off a more permanent inflation threat.

In contrast, if the conflict were to drag on for several months rather than weeks, how would the macroeconomic picture begin to shift? At what point do temporary shocks start becoming structural risks for the global economy?

Philip: It’s difficult to put a precise timescale on it, but if we’re talking about a number of months, then yes, those risks would be very much present, i.e. permanently ingrained inflation. That’s the point at which the central banks get more serious about hiking, because they become more concerned about the inflationary threat than the downside risks to the economy.

The Fed might be an exception here, because it has a dual mandate. It’s not only got a price objective, it’s got a ‘full employment’ objective as well. So, you could argue that the Fed would be more dovish if you like.

We would note though, that the Reserve Bank of Australia cited higher energy prices as a reason, not the only reason, but one of the reasons, for raising rates earlier this week.

As you mentioned earlier, markets currently seem to be assuming this oil shock will be relatively short-lived, but if that assumption proves wrong, where would investors feel the pressure first? Would it be currencies, inflation, or equity markets?

Chris: Typically, equity markets would move ahead of any sizable shock to growth. Normally, equity markets bottom out about six months ahead of a recession, So, we would expect equity markets to reflect concern quite rapidly, and that’s why it’s so surprising that they haven’t moved by much so far.

And with that there would be some moving currencies. Over the past 20 years or so, the dollar has been a very effective, safe haven currency, but post Liberation Day, it hasn’t quite acted in the same way. So, it’s not immediately clear that the dollar would strengthen materially as a result of this conflict lasting a bit longer than expected.

Inflation is typically a lagged indicator. It takes some time for those numbers to come through, but they are very meaningful. And if the inflation trajectory shifts and we land up with much higher numbers, that itself would reinforce the moves that we are going to see in currencies and equity markets.

If Trump were to pull the US out of the war tomorrow, sooner rather than later, what will the impact on the US economy be?

Chris: Well, as Callum mentioned earlier, I think there is still going to be a bit of time before we get back to normality, we’ve got to rebuild inventories. As it is, there’s a price shock and that’ll take some time to correct.

It’s still likely to reduce US growth relative to what were pretty buoyant expectations, say from February. I still see that there's some downside there.

It’s not just the US. I mean, if you think of SA as an example of an emerging market, if oil is at $125 at the end of June, our estimate suggests that inflation in SA would be 7%. And it’s hard to see how the SAR doesn't hike in that environment. And, and that sort of story is going to pan out across emerging markets and it does pose some risk.

If the conflict were to continue and significantly damage oil production or export infrastructure right across the Gulf region, how disruptive could that be for global supply?

Callum: Well, unfortunately, I think that’s where we get into that worst case scenario I talked about right at the start, where inventories run down and the market has to reach a level that disincentivises a sufficient amount of demand, in order to bring the market into a balance.

How high might that be? Well, Brent traded at around a hundred dollars per barrel for several years between about 2011 and 2014, and yet, demand grew over that period.

The all-time high in Brent was just under $150 per barrel, set just before the financial crisis. So, I would think the level at which oil would need to get to, to disincentivise that sort of degree of demand, is going to be $150 per barrel plus. I think it’s quite clear we haven’t seen the worst of it, if that were to become the case.

Before we finish, let me ask each of you, what is the one indicator that you'll be watching most closely in the weeks ahead?

Chris: The first is the number of ships passing through the Strait of Hormuz. We track that on a daily basis. As investors, we also look out for the equity market. We have been defensively positioned up until now, and we are hoping that we are going to see an opportunity in the next month or two to increase our allocations to risk assets.

We’re expecting that there will be some form of pullback in the conflict. If that occurs, we think that the long-term outlook is sufficiently stable and unchanged. If it looks like it’s going to take a bit longer, I think we will see an outsized move in markets. 

What about for oil markets?

Callum: I would say measures other than the Brent Front contract. For example, the price of jet fuel has been particularly severely affected. We’ve seen prices the equivalent of something like $200 per barrel in in jet fuel. The market is very sensitive to developments, and this is what end consumers are actually paying for. People don’t put Brent front contract futures into their tank.

Also, the physical price of oil. If you look at the physical market for oil going from the Middle East to Asia, for example, that’s already at $150 per barrel.

And Phil, what indicators will you be keeping your eye on?

Philip: Well, obviously we watch a very broad suite of indicators to tell us what’s going on in the world economy. I’ll be keeping an eye on President Trump’s approval ratings, because he is very much politically constrained as to what he can do and how long he can do it for because he’s got the Midterm Elections coming up in November.

From what we can see at the moment, his approval ratings haven't actually gone down a lot, but they do stand low, at -15, and if we were to see public opinion turning against him on this subject, then that’s possibly the point where you begin to see the US think about planning a cessation to the war and therefore perhaps that those oil prices come down and you begin to see the inflationary threat ease back a bit.