- The war between Hamas and Israel – and the potential for escalation to the wider region – has increased the uncertainty around the economic and financial market outlook, but in most scenarios is unlikely to generate a sustained hit to major asset markets.
- Events in the Middle East over the past couple of weeks have (again) generated unwelcome uncertainty in financial markets, which is likely to persist for some time. So far, market participants do not appear overly worried that the conflict will have a major impact on the global economy. That relatively sanguine reaction is in line with most similar conflagrations in the Middle East and elsewhere. Major financial markets have typically proven quite resilient to geopolitical shocks over recent years; such events have generally not had significant persistent impact on major markets, even in cases where financial markets in the directly affected country or region take a substantial hit.
- However, there are exceptions to that rule, including Russia’s invasion of Ukraine last year. Those exceptions provide a framework for thinking through how the Hamas-Israel conflict (or indeed future geopolitical crises) could end up affecting the key financial markets in a more substantial way. In our view, history provides three key lessons for how geopolitical shocks propagate to global markets.
- The first, and most obvious, is that commodity prices, especially energy, are the main channel through which such shocks have in the past generated major effects on the global economy and financial markets. The key concern around the Hamas-Israel conflict is therefore that it may widen to involve Iran, an ally of Hamas and a major energy producer. That could send the oil price above 100$/bbl, at least temporarily.
- That said, uncertainty alone has typically not been enough to keep energy prices high for long periods. In other words, it would probably take a major escalation – involving actual disruption to oil supply chains – to generate a shock comparable to last year’s energy crisis in Europe, never mind the oil shocks in the 1970s. Such an outcome still looks like a tail risk, in our view.
- Second, it matters when in the economic cycle a geopolitical shock occurs, because that affects how central banks respond to any economic spill overs. In most recent geopolitical events – aside from last year’s Russian invasion of Ukraine – the Fed has been in a position to cushion the blow. With economic activity generally slowing and inflation pressures easing, policymakers in advanced economies are now arguably in a better position to deploy their usual strategy of “looking through” increases in inflation driven by (hopefully) temporary spikes in energy prices. That supports our base case that government bond yields will fall back over the coming months as central banks end rate hikes and start shifting towards cuts.
- The third lesson is that the fiscal and broader policy context is also important. In addition to the oil shocks, a key underlying cause of the monetary and financial instability in the 1970s was the macroeconomic imbalances that built up during the 1960s. That ultimately brought about the end of Bretton Woods system of managed exchange rates, breaking the link between money supply and gold reserves – thereby removing the “nominal anchor” that policymakers had relied on to keep inflation in check.
- Today, the US’s large and, seemingly, persistent fiscal deficit appears to be a growing concern for investors, contributing to the rise in long-term US Treasury yields. But, while the fiscal outlook in the US (and some European economies) is worrying, the financial costs of the ongoing war in Ukraine and whatever aid is sent to Israel are tiny in relation to US (and European) fiscal capacity. It would probably take a much larger geopolitical shock to alter the fiscal calculus in a meaningful way. More importantly, both monetary and fiscal policy frameworks are more sophisticated and robust than in the 1970s, when policymakers allowed fiscal spending to get out of hand and struggled to replace the Bretton Woods framework.
WHAT’S HAPPENED SO FAR?
In the two weeks since Hamas’s surprise attack on Israel, global financial markets have, for the most part, taken the crisis in stride. While equity markets have generally fallen a bit, in our assessment that reflects mainly the continued rise in long-term government bond yields – which, in itself, is not a development typically associated with worsening risk sentiment. Likewise, the US dollar does not appear to have benefitted in the way that is generally associated with a flight to safety dynamic.
Admittedly, there are some signs of heightened risk aversion in the past couple of weeks. The price of gold, considered by many as the ultimate safe haven, has surged, disconnecting from its usual relationship with TIPS yields and the dollar. And the Swiss franc, another bastion against all manner of risks, has strengthened, nearing its strongest level on record against the euro. But, overall, market participants do not appear overly worried that the conflict will have a major impact on the global economy and financial markets.
ENERGY MARKETS MATTER MOST
The first, and most obvious, is that commodity prices, especially energy, are the main channel through which geopolitical shocks have in the past generated major effects on the global economy and financial markets. They are also the most likely way in which the current conflict comes to affect global market more significantly.
The most recent comparable example is the Russian invasion of Ukraine in early 2022. That led to a surge in energy prices which contributed to the fall in bond and equity prices last year, mainly by driving major central banks to tighten monetary policy even faster than they might otherwise have. And the disruption to Europe’s energy supply led to significant underperformance of European financial assets and large falls in the euro and other European currencies. While that impact has in large part unwound, some of the deterioration in Europe’s terms of trade is still in evidence and its effects may prove long-lasting.
In recent decades, the second Gulf War, the 9/11 attacks and the Iraqi invasion of Kuwait in 1990 had significant, if relatively short-lived, effects on global markets, mainly by driving oil prices up and undermining economic confidence.
Going further back, the first Yom Kippur war back in 1973 and the Iranian revolution of 1979 provide the most worrying precedents. In 1973-4, the oil price quadrupled over the space of a few months after OPEC embargoed exports to the Western powers supporting Israel. In 1979, oil prices more than doubled when Iranian supply was disrupted by political upheaval and US sanctions.
These oil shocks were a major contributor to the stagflation and financial market turbulence of the 1970s,and have provided the “worst case” scenario in Middle East crises ever since.
The key concern around the Hamas-Israel conflict is therefore that it may widen to involve Iran, an ally of Hamas and a major energy producer. With both the oil and LNG markets already very tight, we think that if such a scenario came to be seen as likely, the uncertainty alone could send the oil price well above 100$/bbl, at least temporarily.
That said, uncertainty, by itself, has typically not been enough to keep energy prices high for long periods. Actual disruption to the production and/or transportation of energy has generally been required to generate a sustained effect.
In other words it would take a major escalation – involving tangible disruption of oil supply chains – to generate a shock comparable to last year’s energy crisis in Europe, never mind the one in 1973 following the first Yom Kippur war. In our assessment, such an outcome still looks like a tail risk.
We also think that another oil embargo by the main Gulf producers is very unlikely. Compared to the 1970s,they are far more integrated with the global economy and markets (not least through their massive sovereign wealth funds), and consequently have far more to lose if they went down that route. What’s more, OPEC accounts for a smaller share of overall oil production today than it did in the 1970s (~30% vs ~55%),and advanced economy GDP has become far less oil-intensive since then.
Of course, just because energy markets have been the key channel of transmission for geopolitical shocks in the past doesn’t mean that will necessarily be the case in future. One particular risk that is increasingly on many investors’ radar is tensions between China and the US, with Taiwan as a potential flashpoint. While a US-China confrontation would have wide-ranging ramifications, one key aspect of a crisis involving Taiwan would be the impact on the global supply of semiconductors (of which Taiwan is, by far, the largest producer, followed by Korea).
At this point, semiconductors are an input to so many manufactured goods that disruption to supplies could plausibly have an effect similar to an energy price shock. Indeed, during the initial stages of the COVID pandemic, a surge in demand for electronics led to a global shortage of semiconductors, as producers were unable to scale up production quickly enough. (Like oil fields, semiconductor factories take years to build). That shortage contributed to both the economic slump in 2020 and the inflation pressures during the re-opening phase in 2021-22.
THE IMPACT ON MONETARY POLICY
The second key determinant for how geopolitical events affect global markets is when in the economic cycle they occur, which affects how central banks respond to any economic spill overs.
One reason that the Russian invasion last year and the consequent surge in commodity prices had such a big influence on financial markets last year is that it came at a time when most major economies, boosted by pandemic era stimulus, were already running hot. With labour markets already exceptionally tight and inflation well above target, central banks were responding by tightening monetary policy aggressively. The spike in energy prices exacerbated the inflation situation, leading to fears that second-round effects would re-set inflation expectations higher. That pushed central banks to take an even more forceful approach than might have been the case had the energy shock not happened, or occurred at a different time.
By contrast, in 2001-03 the Fed was already easing monetary policy in response to the economic slowdown in the wake of the bursting of the dotcom bubble, and cut rates further after the 9/11attacks. Likewise, in 1990, the Fed was in a position to cut interest rates soon after the Iraqi invasion. In both cases, that supportive stance helped to cushion the blow to financial markets.
At this point most major central banks appear close to, or at, the ends of their tightening cycles. With economic activity generally slowing and inflation pressures easing, policymakers in advanced economies are now arguably in a better position to deploy their usual strategy of “looking through” increases in inflation driven by (hopefully)temporary spikes in energy prices. That supports our base case that government bond yields will fall back over the coming months as central banks end rate hikes and start shifting towards cuts, even if the potential for amore substantial surge in energy prices that forces central banks to tighten further or hold off on easing is a key risk to that view.
THE WIDER BACKDROP MATTERS
The third lesson is that the fiscal and broader policy context also matters. In addition to the oil shocks, a key underlying cause of the monetary and financial instability in the 1970swas the macroeconomic imbalances that built up during the 1960s. Military spending on the Vietnam War (along with new domestic fiscal commitments) led to large fiscal and current account deficits in the US. Ultimately, that contributed to the end of Bretton Woods system of managed exchange rates, breaking the link between money supply and gold reserves – thereby removing the “nominal anchor” that policymakers had relied on to keep inflation in check.
By contrast, the 1990s and 2000s were periods of generally solid economic growth, robust public finances, and stable inflation. That allowed the US to absorb the substantial (if smaller)fiscal costs of its wars in Iraq and Afghanistan with relative ease.
Today, the US’ large and, seemingly, persistent fiscal deficit has been a growing concern for market participants over recent months, probably contributing to the rise in government bond yields both in the US and, because high-grade government bonds are often considered to substitutes, elsewhere too. The renewed focus on geopolitics over the past couple of years could become another strain on public finances. So, investors may worry that, for the US (and Europe) the expense of supporting Israel against Hamas (and potentially Iran), pre-existing commitments to Ukraine in its war against Russia, and the necessity to counter China’s military build-up in the Pacific might add up to the point that defence spending grows to such an extent that it again affects macroeconomic outcomes in a significant way. (In effect, a modern version of the “guns or butter” trade-off familiar from many Economics 101 textbooks.)
We think the probability of such an outcome still looks limited. The fiscal costs of the war in Ukraine and whatever aid is sent to Israel are tiny in relation to US and European fiscal capacity. US military spending as a share of GDP is considerably smaller now than in the 1980s, never mind the 1960s. Europe has long prioritised butter over guns, and looks unlikely to increase spending on the former to the point that it affects fiscal stability.
More importantly, both monetary and fiscal policy frameworks are more sophisticated and robust than in the 1970s, when policymakers allowed fiscal spending to get out of hand and struggled to replace the nominal anchor provided by the Bretton Woods framework. Indeed, the aggressive tightening of monetary policy over the past couple of years has been motivated in large part by central bankers’ determination to avoid a similar outcome as in the 1970s. While fiscal policy appears less disciplined, our base case is that sufficient steps will be taken to avoid deficits (or government bond markets) in the major economies from spiralling out of control.
WHERE DOES THAT LEAVE US?
The most likely scenario with respect to the Hamas-Israel war, in our view, is that it remains limited enough that the impact on global financial markets stays small. With most major economies slowing and inflation pressures easing, the Fed and other major central are likely to shift towards easing policy next year, thereby bringing long-term bond yields down. Equities and other “risky” assets will probably continue to struggle in the near term as the global economy falters, but rebound once the outlook brightens towards the middle of 2024. The most plausible outcomes in the Hamas-Israel war would not alter that picture materially.
There is, clearly, ample room for disappointment if that relatively sanguine view (which appears broadly to be what is discounted in markets) proves too optimistic. Another energy price shock, even a relatively small one, would damage global growth prospects and might force central banks to maintain their current hawkish stance for longer than we anticipate. US fiscal policy is already in a problematic spot and, given that perceptions matter as much as the underlying figures when it comes to debt sustainability, it may not take much further bad news – whether on the geopolitical front or from elsewhere – to trigger a “bond vigilante” episode in Treasury markets.
An article by Capital Economics, 26th October 2023
Written by Jonas Goltermann
Deputy Chief Markets Economist
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