Will the Iran conflict undo Goldilocks?

With the conflict in Iran now approaching the end of its first week, today’s Brief analyses the possible impacts on the global economy and financial markets over the coming six months. As such, we concentrate on the impact of higher energy prices.
 

Of course, underlying the more immediate impact of higher energy prices are the potential tectonic shifts in global economic and security relations of which the current crisis is but one manifestation. Such tectonic changes are potentially more significant than near term energy-price shocks, but are longer term in nature, and the subject for a future Weekly Brief. For today, we keep our sights fixed on the coming 6 months.

The impact on the global economy and financial markets remains uncertain, with risks rising as the conflict continues. It is increasingly likely that the conflict will not be of the “weekend war” nature of Venezuela, or of the 12-day conflict in June last year which targeted Iranian nuclear sites.

Nor is it likely to resolve within weeks, as did previous Gulf War conflicts of the two Bush (senior and junior) Administrations of 1991 and 2003. In the Bush Gulf Wars (against Iraq), the US committed ground troops which overwhelmed Iraqi resistance, bringing the war to an end.

The likelihood of the US committing ground troops to the Iranian conflict is remote. First, Iran is a far more formidable opponent than Iraq. Iranian troops number around 1 million comprising 610,000 regular and Islamic Revolutionary Guard Corp troops, and 350,000 reservists.

In contrast, the Iraqi regular army numbered just 350,000 during the 2003 war, of which only around 100,000 were properly trained and equipped, with only the 75,000 Republican Guard being an effective military unit. In addition, today’s conflict is fought in the modern era of drone warfare, of which Iran is at the forefront.

Second, the current conflict is unpopular in the US. Current polls show that around two thirds of Americans oppose the Iran conflict, with only around 30% supporting the Administration. In contrast, public support for the Bush Administration’s 2003 war against Iraq was high, with around two thirds of Americans in support.

Without the commitment of ground troops to an invasion of Iran, the conflict is likely to drag on for months rather than weeks. What does an extended conflict mean for the global economy and financial markets?

The most direct transmission of the conflict to the economy and markets is via its impact on global energy prices; namely, oil and gas. How high and for how long oil and gas prices rise will largely determine the economic and financial market impact of the conflict over 2026.

Here, the Ukraine/Russia war can provide some guideposts. In response to the Russian invasion of Ukraine, oil prices quickly moved above US$100/barrel(bbl) (from around US$90/bbl prior to the war) and averaged around US$115/bbl for six months from March to August.

European natural gas prices also spiked, with prices averaging around 150% higher during the first six months of the Ukraine/Russia war than the pre-war average. The impact of the surge in energy prices on the economy and financial markets during the first six months of the Ukraine conflict was significant.

Higher energy prices contributed to a surge in global inflation, forcing central banks to lift interest rates. The US Federal Reserve (Fed) raised the fed funds rate from a pre-war bound of 0-0.25% to 5.25-5.50% by July 2023.

Higher inflation and interest rates contributed to a slowdown in economic growth, with the US economy stalling in the first half of 2022. Financial markets also took a hit, with US equities down almost 20% between February and August 2022 (as measured by the S&P 500) and US 10-year bond yields lifting from around 2% to 4%, where they remain to this day.

With the Ukraine experience in mind, one would have to conclude that the market response to the current conflict is sanguine. Oil prices have risen, from around US$73/bbl prior to conflict to around US$85/bbl; still some distance from US$100/bbl or the $115/bbl average of the Ukraine conflict. European natural gas prices have risen by about 50%, cf 150% of the Ukraine episode, the US equity market has barely shed 1% and bond yields are up just 20 basis points.

Finally, and most importantly from a monetary policy perspective, longer-term inflation expectations have remained well anchored at around central banks’ targets. For example, the 10-year average inflation expectation in the US remains around 2.3%, close to the US Federal Reserve’s (Fed) target, as measured by the CPI.

During the outbreak of the Ukraine/Russia war, inflation expectations spiked to 3%, indicating that inflation was at risk of spiralling out of the control of central banks. It was this risk of unanchored inflation expectations, that induced central banks to raise rates over 2022.

Can we conclude that markets are currently complacent? Before we do, we must first recognise the differences between the global economy now and in 2022.

The most important difference is that the economy of 2022 was characterised by excess demand generated by the enormous global fiscal response to Covid. This made the economy susceptible to price shocks, such as the war-induced spike in global energy prices.

In addition, central banks were still suppressing interest rates, as evidenced by the US fed funds rate that was still being held at close to zero. The energy-price shock, layered on top of the inflation impulse from excess demand, necessitated a sharp response from central banks that led to a global surge in interest rates.

By contrast, leading into the current crisis, the post-2022 rise in interest rates has been successful in bringing demand and supply conditions back into balance, reducing the rate of global inflation, and thereby making the global economy more resilient to spikes in energy prices. Even if the conflict endures for months rather than days or weeks, as long as the impact on energy prices is perceived to be temporary, central banks can afford to “look through” the eventual spike in prices, refraining from raising interest while waiting for the spike in inflation to pass.

This does not mean that a sustained (say, six months, as in the case of the Ukraine conflict) spike in energy prices won’t do damage to the global economy – it will. But if central banks don’t have to respond with higher interest rates, the compounding effect on the economy will be limited, as will the transmission to financial markets, particularly equities and other risk assets.

To better understand the potential fall out of the Iranian conflict, we have used NiGEM, a model of the global economy, to simulate the impact of a six-month war. In our simulations, we drove oil prices to an average of US$120/bbl for six months and imposed a 200% increase in global gas prices.

Due to the temporary nature of the shocks, we held central bank policy rates constant in the simulations. Even with a temporary shock, the impact on economic growth and inflation is significant.

Our results indicate that inflation could lift across the OECD economies by around 1½-2 percentage points (ppt) and GDP growth would be cut by around ½ ppt. However, with central banks holding interest rates constant, borrowing costs remain stable providing a cushion to households, businesses and equity markets.

However, if a perception grows that the war, and hence the shock to prices is ongoing, then, as during the Ukraine conflict, a different outcome will emerge. If a higher rate of inflation becomes embedded in longer-term expectations, central banks would need to respond by raising rates to contain a potential inflationary spiral.

If that happened, it would expose the current fragility of the equity market, where valuations are almost as stretched as they were just before the bursting of the dot.com bubble at the turn of the century. The fallout would be a bear market in equities, which in turn, would place downward pressure on economic growth as consumer spending fell in response to a sharp decline in household wealth (particularly in the US) and as the cost of capital rose for businesses.

The further slowdown in economic growth could undermine confidence in the ability of AI related companies to deliver the earnings outcomes that underpin current equity valuations. In this scenario, we shift from a benign outcome for the global economy, to a recessionary outcome, and from a benign outcome for financial markets to a full-blown risk-off outcome.

What should investors have their eyes on in navigating the coming months? If we are correct about hostilities dragging out and an absence of the commitment of ground troops by the US, then the level of longer term (say 10 years and 5-year/5-year) inflation expectations will be the key to anticipating central bank responses. If these expectations drift up toward 3%, then central banks will be forced to lift rates, raising the probability of shifting from the benign to the malignant scenario.