Middle East war: a geopolitical shock with global ramifications

Escalating tensions between the United States, Israel and Iran usher in a new phase of uncertainty in the Middle East. Markets brace for the economic shock waves amid fears of an oil shock, renewed upward pressure on inflation and a slowdown in global growth.

The US and Israel launched a massive joint military operation against Iran on 28 February. The US administration has stated a number of war objectives, including destroying Iran’s nuclear programme, annihilating its military capabilities and regime change.

Following intense air strikes that killed Iran’s supreme leader, Ayatollah Ali Khamenei, and some 40 other senior regime leaders, Iran’s retaliation was swift. Its strategy is essentially two-fold:

First, export the conflict across the Middle East. Iran’s military has sent drones and fired ballistic missiles against American military bases, embassies and consulates in neighbouring countries with the aim of destabilising the entire region.

Second, choke off the Strait of Hormuz, the crucial sea passage for around one-fifth of the world’s supply of oil and liquefied natural gas. Oil and gas prices surged as a result, threatening the global economy and weakening the Trump administration at home as the mid-term elections approach.

Traffic stalled in the Strait

Technically speaking, Iran hasn’t blocked the Strait of Hormuz, but maritime traffic is practically at a standstill as security threats send maritime insurance premiums skyrocketing. Stalled oil flows through the Strait have put pressure on storage capacity and forced the region’s oil producers to cut back on production. For example, Iraq, the fifth-largest crude oil producer in the world, has slashed output by more than 50%. Kuwait, the United Arab Emirates and Saudi Arabia have announced similar measures

A cold wind is also blowing in the gas market. In Qatar, which supplies 20% of the world’s LNG, state enterprise QatarEnergy has halted production after attacks against its facilities.

Oil and gas prices soar

Surging oil and gas prices constitute the main risk to the economy. If sustained, a sudden throttling of supply would automatically lead to stagflation, i.e. stagnant growth coupled with high inflation. Europe and Asia would be far more exposed than the US. Yet, we think that tighter monetary policy isn’t the right answer in this context, since the surge in prices stems from supply disruption, not increased demand.

Growing political fallout in the United States forces Trump to react

One week into the conflict with Iran, investors’ optimistic hopes of a quick resolution are waning somewhat. The appointment of Mojtaba Khamenei as Iran’s supreme leader to succeed his father, Ayatollah Ali Khamenei, is a signal of defiance. Moreover, the political cost of the war for the Trump administration is increasing with polls suggesting very tenuous support among Americans. With the mid-terms on the horizon, soaring energy prices, especially at the pump, are a worry.

Weakened domestically, Donald Trump sought to calm markets by saying the war would end very soon, prompting a significant drop in oil and gas prices.

Markets under pressure

European markets have wiped out practically all the gains since the start of the year. Long rates rose amid heightened inflation expectations. The US dollar strengthened, reflecting its safe-haven appeal.

Historically, periods of escalating geopolitical tension have provided attractive entry points into the equity markets. However, the duration and intensity of the conflict are crucial determining factors. In our view, it is unlikely the Trump administration will drag out the conflict so close to the mid-term elections.

Damien Petit, CFA, Head of Private Banking Investments,
Banque de Luxembourg