Middle East conflict: counting the cost of disruption

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00:00 – Introduction 

Jeremy:  War in the Middle East is sending tremors through the global economy. The escalating conflict has pushed oil prices to record highs and has placed one of the world's most critical shipping routes, the Strait of Hormuz, under strain. Yet as we record this episode on the 17th of March, financial markets appear relatively calm - at least for now. Are investors assuming this disruption will be short-lived? And what happens if it isn't.

Welcome to No Ordinary Wednesday, an Investec Focus Radio SA podcast, where we examine the forces shaping markets and the global economy. I'm Jeremy Maggs.

Energy shocks have a habit of lasting longer than expected and when they do, the consequences ripple through inflation, growth and investment markets. In this episode, we examine the conflict’s implications for the oil market, global growth, the investment landscape and for South Africa.

Joining me are three Investec experts. From London, we have Callum MacPherson, Head of Commodities and Phil Shaw, Chief Economist, who are both from Investec UK. In Johannesburg, we are joined by Chris Holdsworth, Chief Investment Strategist at Investec in South Africa.

Chris, Phil and Callum welcome to No Ordinary Wednesday.

01:11 – Oil price - genuine supply disruption or market pricing geopolitical uncertainty?

Jeremy: Callum, let's start with the oil market. We've been seeing wildly fluctuating prices and even a surge above that psychologically important US$100 per barrel mark. To what extent is this price behavior a reflection of genuine supply disruption versus a market trying to price geopolitical uncertainty?

Callum: There is genuine destruction. Something like 20% of world supply is currently unavailable because of the war that's going on, which is absolutely unprecedented. I think even if the war was 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 just to snap back to where it was in say 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, the consumption of oil, is going to have to be cut back so that it's in line with actual supply. At some point inventories will be exhausted, then we will reach a stage where there's no alternative but to cut back demand. Cutting back demand by 20% would be something like what we saw during COVID in terms of the restrictions on mobility and business activity, that would be required to bring consumption of oil back in line with available supply of oil if this supply disruption continues. So, 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 at in order to disincentivise that amount of demand, it's probably much higher than we've already seen. So we talked about U$100 per barrel, we did see nearly $120 per barrel briefly on Brent, but it may need to go a lot higher than that. So, the market at the moment is trying to work out where on this spectrum are we 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. It's very hard for the market to know, which is why things are so volatile.

03:26 – What damage has already been done to the global economy?

Jeremy: Phil Shaw, let me turn to you. Geopolitical shocks don't always translate into economic shocks. Markets sometimes absorb them quite quickly, but looking at this conflict as it stands, what damage has already been done to the global economy?

Phil: That's true but clearly this is a geopolitical shock that is material, where you've had something like a 40% surge in old prices in dollar terms since the attacks on Iran began and spot natural gas prices have close to doubled.

It's still relatively early days but you can see the negative impact on confidence in the economy beginning to creep in from some early surveys. Where we stand from here is that longevity of the shock is critical.  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 will also hurt consumer spending, as the households pay for more energy they have less money to spend on other items.

One redeeming factor, at least for 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.

04:43 – Do investors see the disruption as temporary?

Jeremy: Chris, let's turn to the investment landscape. Markets have remained relatively composed so far. Why do you think the response has been restrained? All things considered, do you think this 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 would be quite sensitive. 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.

If you look at equities – equities are down but they're down a couple of percent. It does seem to be the case that markets are pricing in this whole scenario, the shortages that Callum spoke about with regards to oil 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. If it does persist a bit longer and that's a non-negligible possibility, then it does suggest that there is some downside ahead.

05:50 – If the conflict is prolonged, what would be the first risks likely to emerge in financial markets?

Jeremy: Chris, if the conflict 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 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 you look at South Africa, the market was looking at about one to two and already those have been ruled out.

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

I think that's the sort of plan, the trajectory as it would pan out in the event that it does persist and we need to keep a very close eye on those medium-term inflation expectations.

06:54 – Are markets underestimating economic risks?

Jeremy: Phil, do you think markets are underestimating the economic risks of this conflict?

Phil: I think you could argue that at least in some markets, if you look at equities, we've had something like a three to four percent retracement in the S&P500, which is basically saying no lasting damage to corporate earnings.

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 US, they are pointing to perhaps one quarter of a point cut by the Fed this year, but they're expecting one and a half interest rate increases from the ECB before the end of 2026, and roughly a 50% chance of one increase by the Bank of England. I think we would say that this is probably pricing in too much bad news, i.e too much high inflation.

07:58 - Does oil reserve release meaningfully stabilise markets?

Jeremy: Callum, let me come back to you then. The International Energy Agency has already announced a 400-million-barrel reserve release but with the conflict showing no clear end, does this meaningfully stabilise the markets? Or does it simply buy time?

Callum: The maths of this is relatively straightforward. Four-hundred-million barrels and we've got a supply disruption of let's say something like 20% of world supply, around 20 million barrels per day. This reserve release is equivalent to about 20 days’ worth of current disruption and the war is getting on for something like 20 days. What this reserve release does is replace the barrels that have so far been disrupted. Obviously it helps but it isn't a solution. If the war continues much longer, then this will clearly not be enough.

The other problem is that even if the war does end relatively quickly, inventory has been or will be released. Once you've released that inventory, your inventories are then lower. The ability to deal with any further disruptions, perhaps if the war started up again or something else happens, is then reduced. The market needs to price for that in potentially an ongoing risk premium.

09:14 – How might damage to oil infrastructure play out in the market?

Jeremy: Callum some analysts suggest that the bigger risk now is not only shipping lanes but potential damage to Gulf oil infrastructure. How might that play out in oil markets?

Callum: It's difficult to assess exactly how much damage has happened 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 Saudi production processing plant, which took offline about 50% of Saudi production, it was restored pretty much to full capacity in about a couple of weeks. So, it depends on the extent of the damage.

There have been suggestions from the Americans in recent days that they might destroy the oil terminal on Kharg Island, which is the main source of output for all of the Iranian production in terms of how it accesses world market. Were they to do that and completely destroy it, that would be a serious problem. It would take a very long time to replace that. But so far, we haven't had anything on that scale.

A lot of it is precautionary, shutting things down, not necessarily that sort of scale of damage, but of course we don't know how things might go from here.

10:30 - How quickly do energy shocks feed into global inflation?

Jeremy: Phil, 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?

Phil: 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 that increase.

The danger is that that 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 of permanently higher inflation. It means that central banks have to lean against is quite hard with higher interest rates and that's where you get a stagflationary risk or at least you get higher inflation and a lower growth environment.

11:35 - Where do investors typically find resilience during energy shocks?

Jeremy: Chris Holdsworth to you then, from a portfolio perspective where do investors typically find resilience during energy shocks?

Chris: It's very difficult to. Normally in the event that 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.

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 let's assume from the moment that it does persist and oil remains at a US$100 for some time in that environment, you require hard assets. Equities actually over the long run, do provide protection against inflation but it is over the long run.

So, it's a question around the stage that we see. In the short-term, there's not much protection from anything except for cash and over the long run you need to be in hard assets and equities.

12:54 - Could the war delay South Africa’s expected economic recovery?

Jeremy: Chris before we get into scenarios, let's bring this home to South Africa. Could the war delay the country's expected economic recovery?

Chris: Absolutely, for a variety of reasons. As a start, it rules out the possibility of rate cuts. In fact it means that we may well get rate increases in SA and it may well put pressure on the rand. In addition fuel is about 4% of the consumer basket, so it's a tax on consumption in effect. And all those things put together means that it does dim the outlook for SA economy.

13:29 – How high could petrol prices in SA go?

Jeremy: What could we expect to pay at the pump?

Chris: That's hard to tell. What we can say is that already given where prices are at the moment, we could probably pencil in an increase in the fuel price next month of about R4 a litre. It's a pretty sizable increase and it will have a knock on SA consumption.

13:45 - Could higher commodity prices provide any offsetting benefits for SA?

Jeremy: Is there a potential upside here though, Chris? Could the higher commodity prices that we've been experiencing over the past couple of months provide any offsetting benefits for South Africa?

Chris: Commodities that SA exports have done very well over the past two yearsand they are certainly going to take the edge off this. Fortunately, South Africa exports a lot of gold. If this does persist for a long time, gold would typically do better than most commodities even if not over the short-term. So that certainly does help. But even we cannot escape the fact that SA is vulnerable to an energy price shock.

14:19 - Does the conflict raise inflation risks and a potential hike in rates in SA?

Jeremy: Chris the rand has weakened. Does this raise inflation risks and potentially force a hike in rates?

Chris: I think the risk rather lies with energy directly. If you look a year ago, the rand was materially weaker than it is now in large part because of the strength of commodities that we've seen. So that drew the rand stronger over the past year and we  are still in an environment where I don't think the rand by itself is adding inflationary pressure. It's more around oil in particular.

14:45 – If the conflict continues for weeks, what would change materially from a macroeconomic perspective?

Jeremy: The economic consequences of this conflict will ultimately depend on how events unfold. So it may be useful to consider a few possible scenarios. Phil, let's look at scenario one. If the conflict were to drag on for another few weeks without meaningful deescalation, what would begin to change materially from a macroeconomic perspective?

Phil: If we're talking about the conflict lasting a number of weeks, that's probably a relatively benign outturn. It might take time for oil supply to get back fully on stream and we may not see US$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. What you then see is inflation rising for a while but then it comes down as oil prices ease back. 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. What you don't get is a series of rate increases to stave off a more permanent inflation threat.

15:59 – If the conflict continues for months, how would the macroeconomic picture begin to shift?

Jeremy: 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?

Phil: 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 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 but also a full employment objective as well. You could argue that the Fed, if it were to come to certain interests certain and central banks raising rates, 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.

16:59 – If the conflict continues, where would investors feel the pressure first?

Jeremy: Chris 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? 

Chris: Typically, equity markets would move ahead of any sizable shock to growth. Normally equity markets bottom about six months ahead of a recession turning, as an example. 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 but it's difficult to say at this point because over the past 20 years, or so, the dollar has been a very effective safe haven currency and post-Liberation Day it hasn't quite acted in the same way.

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 meaningful. 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.

18:09 - What will be the impact on US economy?

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

It still is likely to reduce US growth relative to what were buoyant expectations, say from February. I still see that there's some downside there, it's not just the US.

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

18:57 - How disruptive could infrastructure damage be for global supply?

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

Callum: Unfortunately, I think that's where we get into that worst case scenario where inventory is 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? Brent traded around a US$100 per barrel for several years between about 2011 and 2014 and yet demand grew over that period.  If your inflation had adjusted, you come up to a level much higher than $100 now. The all-time high in Brent was just under US$150 per barrel set just before the financial crisis.

I would think that the level at which, nobody really knows, but the level at which oil would need to get to disincentivise that sort of degree of demand is going to be probably US$150 per barrel plus. So I think it's quite clear we haven't seen the worst of it, if that were to become the case.

20:05 - One indicator to watch closely?

Jeremy: Let me ask each of you what is the one indicator that you'll be watching most closely in the days and weeks ahead?

Chris: There’s two. The first is the number of ships passing through the Strait of Hormuz, we track that on a daily basis. But for us we are investors and we are looking 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 call it a month, or two months, to increase our allocations to risk assets. We are expecting that there will be some form of a pullback and in the event that occurs, and we think that the long-term outlook is sufficiently stable and unchanged, we'll use as an opportunity to buy some assets.

The problem is that I think everybody's got the same view and that's why the market hasn't moved by much. Everyone thinks it's going to be temporary, and that means that if it looks like it's going to be a bit longer, I think we will see an outsized move in markets.

Callum: I would say measures other than the Brent Front contract. So things like the price of jet fuel have been particularly severely affected. We've seen prices of equivalent of something like US$200 per barrel 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 Font contract futures into their tanks and also the physical price of oil. So, if you look at the physical market for oil going from the Middle East to Asia, for example, that's already at US$150 per barrel.

Phil: Obviously, we watch a very broad suite of indicators to tell us what's going on in the world economy. It would be tempting to say we're watching the oil price, which of course we will be, but something slightly different. What I'd say is what I'd be keeping an eye on is 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.

He's got the midterm elections coming up in November and a big slide in his approval ratings would put pressure on him to simply declare victory in Iran and give up the conflict. Now from what we can see at the moment his approval ratings haven't actually gone down a lot,but they do stand low at minus 15.

If we were to see public opinion in general 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.

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