As the conflict between Israel and Hamas enters its second month, and Iranian proxies sporadically attack both Israel and American targets, we show the geopolitical risk index from the academic group Economic Policy Uncertainty below. This group creates indices relating to policy challenges ranging from infectious diseases to wars, tracking newspaper archives going back decades. The situation in Gaza has driven the risk index sharply higher, but it remains well below the shock of Russia’s invasion of Ukraine in early 2022.
Source: Economic Policy Uncertainty, MacroBond
The economic consequences of wars are so complex and uncertain, that few would be brave enough to pontificate on outcomes. It is possible that the new war in the Middle East, largely confined to the Gaza Strip at this stage, will not expand to include other regional powers such as Hezbollah in Lebanon, or the Iranians (either through proxies in Syria, Iraq or Yemen or directly). Initial market reactions suggested that some investors feared it might. Oil jumped 7% in the two weeks after the 7 October atrocities, perhaps in anticipation of potential supply disruptions. Gold was up 8%. On 19 October, the 10-year Treasury (briefly) yielded more than 5% for the first time since 2007. US stocks were down 2%. Gold’s gain despite the rise in yields (which would normally depress gold prices) was noteworthy. But since then, most of these indicators of surging volatility have calmed somewhat. The CBOE Volatility Index (VIX) has dropped from above 20 to below 15 – a sign of lower volatility risk.
Yet this is most definitely not a time for complacency. The Middle East remains far and away the world’s most important energy producer, according to the Financial Times Martin Wolf, “with 48% of global proved reserves and 33% of production last year. Oil still accounts for more than 30% of global primary energy consumption and a fifth of the world’s supply passes through the Strait of Hormuz”.
Fortunately, the world is less reliant on oil shipped from the Persian Gulf than it was in the 1970s, because total global output is less oil-intensive, and US domestic production has grown sharply. But military escalation that, say, leads the US to carry out retaliatory strikes against Iran – or merely to toughen up its sanctions regime – would be bound to disrupt at least some of the 1.5 million barrels of oil that Iran now exports every day.
The World Bank estimates that any conflict that reduces Gulf exports by 2 million barrels a day (which is 2% of global supply) would raise oil prices to between $93 and $102 a barrel. A major war that reduced exports by 6 to 8 million barrels a day would drive oil up to somewhere between $141 and $157. Natural gas prices are already up by more than a third since the war began.
The great threat to financial markets at present is a significant escalation of war in the Middle East, which causes oil prices to spike with inflation to follow. If this war escalates (and at this stage, we think that is not probable), there is a good chance that oil will rise above $100. A 20% rise in oil prices could add around 0.5% to headline CPI. In that scenario, the recent market narrative that rates have likely plateaued might prove to be optimistic.