After the outbreak of the conflict in Iran and the closure of the Strait of Hormuz, the economic and financial consequences were immediately felt on the stock markets. As the conflict expands on a regional scale, involving the major powers of the Middle East, we delve into some effects already visible after these first ten days of war.
CURRENT OIL SITUATION
Oil prices approach $120 per barrel before falling back to $100, what is defined as a “squeeze” movement, that is a strong rise followed by a strong bearish move. The overall situation is not good: even the surpassing of the $80 area could have been a problem in the short term, and now we are well above these prices.
Given the technical situation, unless there are important geopolitical developments that could reverse the situation, oil is strongly bullish and surpassing the $80 area, then $93, is marking a long-term trend change.
INFLATION EFFECT – ECONOMIC SLOWDOWN
This price increase could have a very significant impact on global inflation. After tariffs, we now have the price of oil representing what is called an “exogenous” shock, meaning it is not generated by demand, but by the sudden price increase due to events beyond the control of the economy.
The price of energy directly affects inflation by increasing costs for families and businesses, therefore increasing the prices of services, transportation, goods—in essence, everything that moves within the economy. Production costs also rise; the increase in energy prices is passed on to businesses, which will transfer, wholly or partly, this increase to the consumer.
If oil remains well above $70 (very likely in the current situation) for several weeks, the inflation effect will be visible on a global scale. However, this inflation increase is dangerous as it negatively affects families and businesses; therefore, the slowdown in consumption and production could lead to a strong economic slowdown. The likely scenario could initially be stagflation, then recession, both in Europe and the US.
EFFECT ON INTEREST RATES
In this case, the equation “High Inflation = Rising Rates” may not hold true. In the presence of such a strong exogenous shock and an inflation increase forced from outside, raising rates would be a hard blow to the economy, which would find itself in distress with a high cost of credit, slowing the financial system and triggering a negative spiral that would lead to a very strong recession.
Central banks, therefore, still maintain a view leaning towards rate cuts in the West, even in the presence of rising inflation. A fundamental role will be played by unemployment both in the US and Europe. Should we see rising inflation and rising unemployment (which usually have opposite trends), central banks will then be forced to remain steady or even cut rates aggressively.
EFFECTS ON THE STOCK MARKET: GOVERNMENT BONDS ARE THE SAFE HAVEN
Given the situation on rates and a possible economic slowdown, the effect on equities could be very negative and could last for months. Conversely, given the remote possibility of rate hikes by central banks, government bonds would be the only true safe haven within the markets and the financial system.
Unlike gold, seen as the ultimate safe haven, government bonds are used by the financial system to regulate reserve requirements essential for system stability, actions that are practically impossible with gold. For now, markets are selling everything; only oil and the Vix (volatility index) are rising. In the future, we could therefore see a flight to quality, that is a tendency to seek safety in the bond market at the expense of the stock market.
THE GULF COUNTRIES AND THE STRAIT OF HORMUZ
Tensions in the area are at their highest levels. The Strait of Hormuz, a key hub for trade between Asia and Europe, has effectively been closed with a strong limitation of international merchant traffic, the first crisis element in the area. Problems also come from the Gulf countries (GCC) which, having been attacked, are losing their image as a “safe harbor.” The American outposts, the bases present in the GCC countries, have been attacked without being adequately defended by those who promised peace in the area (the US). This creates a radical change in the image of the GCC countries, which could now be seen as unsafe and geographically subject to further problems, both military and political.
We recall that most of these countries have a strong dependence on trade, especially regarding the food sector, which sees 80% of imports. Regarding water, these countries depend on desalination plants which, if targeted by military attacks, could make the area inhospitable. The image of these countries could be highly compromised; we could witness an exodus of businesses, capital, and people if the current situation worsens.
