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A storm in a northern hemisphere summer teacup or the shape of risks to come?
Storm clouds around the Iran/Israel conflict have dissipated as quickly as (if not quicker than) they took to form. From the outbreak of the conflict, beginning with the initial bombardment of Iran by Israel about two weeks ago, the oil price climbed by 15% from around US$65/bbl to a peak of US$75/bbl by last weekend, threatening to continue towards US$100/bbl.
Following the US intervention over the weekend and the subsequent ceasefire, the oil price has retraced these gains to be, once again, trading at around US$65/bbl. Equity markets, having put the brakes on for a couple of weeks, are in the process of recovering lost ground and are up by 3% since the weekend, while bond markets have quickly shed any inflationary fears they may have been harbouring about higher oil prices with yields on 10 year US Treasuries down by 10 basis points.
So, is it all just a storm in a teacup and we can resume business as usual? If so, how do recent events in the Middle East fit with the “escalating geopolitical risks” narrative so popular among asset allocators and financial market commentators? Is the escalation in Middle East tensions following June 13 not an example of rising geopolitical risk? If so, why have equity, bond and oil markets shrugged off the risk so blithefully?
There is one market that has seemingly bucked the trend: the currency market. Here, the USD has fallen steadily since the start of the conflict, losing around 5% since its high point on June 13th, continuing the trend that sees investors shying away from US assets as policy uncertainty continues to undermine confidence.
While things have settled down for the moment, the Middle East remains a source of global instability and must be considered a vital piece within the suite of geopolitical risks. Of course, the main transmission of this risk to the global economy and financial markets is via oil prices. But given the improvements in efficiency, shifts to renewable energy sources and the increase in supply brought about by US shale oil, how big a risk does a higher oil price pose? If we consider the immediate risk of a shut down in Iranian supply, the answer is not much.
Iran represents a relatively small share of global oil supply, exporting 2.6 million barrels per day (mbd) or about 2-3%. OPEC countries would have little trouble covering for any loss in Iranian supply with the Energy Information Administration estimating there was around 4.8 mbd of spare capacity in the March quarter. In addition, stocks of oil in OECD countries are healthy, sitting at around 2,700 million barrels of oil, which equates to around one-month of total global supply. Hence, if oil disruptions were limited to Iran, the market is well-placed to respond.
But should we be so narrow in our focus? What are some of the broader risks associated with disruption of oil supply from the Middle East? Turning back to Iran, one example is their ability to disrupt oil exports from the Persian Gulf through their control of shipping through the Strait of Hormuz. Around 20% of the world’s supply of oil and petroleum products is shipped through the Strait of Hormuz, with around 40% going to China.
In fact, oil shipped to China from the Gulf represents around a third of China’s total oil supply. Escalation of tensions in the Middle East, if it is to be ongoing, must raise the probability of a broader and deeper oil supply disruption than just the threat posed by Iran. The exact probability of that threat is unsure. But what if the threat were to eventuate. How important would it be?
To assess the risks, we undertook scenario analysis of a 20% permanent increase in oil prices, which would have taken oil prices to around US$90/bbl from their recent high point. We also apply a shock to equity risk premia and corporate credit spreads to reflect a loss in investor confidence. We calibrate the risk premia and credit spread shocks on market outcomes in response to the US’s 2003 invasion of Iraq (Operation Iraqi Freedom).
Had the current crisis led to this outcome, we find that it would have shaved around 70bps from OECD and US economic growth in 2026 and about 50bps from Australian growth. Such a hit would take OECD and US economic growth to less than 1% in 2026, and the Australian growth rate to 1.8%, yet another year of below potential growth. However, the shock would also lift inflation, with OECD and US inflation rising by around 50bps in 2026 and Australian inflation rising by around 70bps. In the OECD, US and Australia, this would be enough to push inflation back above 3% over 2026 and threaten the easing cycle currently underway across Developed Economies including Australia. It also provides a catalyst for a correction in equity markets which our modelling shows could fall as much as 10%.
More generally though, with most “geopolitical risk” scenarios that we simulate, we find that they generate a stagflationary outcome; from Ukraine/Russia War to Tariff Wars and Deglobalisation, to Energy Transition and Net Zero Emissions by 2050 to Lower Immigration, and, of course, Oil Price Shocks. A theme is clearly developing.
That theme is that the risk imposed by geopolitics tends to be stagflationary and is negative for both equities and bonds. Consequently, the historical response to heightened risk (i.e., out of equities and into bonds) is most likely not the correct response in a world where heightened risk has its roots in geopolitics.