Will the new Middle East crisis rock the world economy? The markets say no – but I fear they’re wrong | Larry Elliott

Donald Trump's early departure from the G7 summit, interpreted as a sign of potential US military action against Iran, has raised concerns about a new Middle East oil shock. While the market reaction has been relatively muted with oil prices increasing by $10 a barrel, the risk remains that escalating tensions, particularly the potential closure of the Strait of Hormuz, could send prices soaring and exacerbate global economic challenges already present from the Covid-19 pandemic and the Russia-Ukraine war.

Analysis

Financial markets are interpreting Donald Trump's early departure from the G7 summit as a signal of potential US military engagement alongside Israel against Iran, reigniting concerns of a Middle East oil shock. Historically, such conflicts, like the Yom Kippur war leading to a fourfold increase in crude prices and the Iran-Iraq war causing a doubling, have severely impacted the global economy through stagflation and recession. Currently, the market reaction has been comparatively subdued, with oil prices rising by approximately $10 a barrel from a base of around $75, a move anticipated to cause only a modest inflationary impact. This muted response is attributed to factors such as OPEC's diminished influence, reduced Western dependency on imported oil, the growth of alternative energy sources, and Iran's smaller share (4%) of global oil production. However, significant risks persist; direct US involvement could escalate the conflict, potentially leading Iran to attempt a closure of the Strait of Hormuz, through which 20% of global daily oil supply transits. Such an event could cause oil prices to surge well above $100 a barrel. Markets are currently pricing in a scenario where the conflict remains contained, Iran's military capabilities are diminished, and major powers like Russia and China avoid deeper involvement. This optimistic market positioning contrasts with the underlying fragility of Western economies still grappling with repercussions from the COVID-19 pandemic, prior energy shocks, and persistent inflation, exemplified by UK inflation at 3.4% remaining above the Bank of England's 2% target. The situation carries a 'moderately negative' sentiment and a high market impact score of 0.7, underscoring the potential for severe economic disruption if the conflict escalates beyond current market expectations. Should oil prices spiral, the article suggests policymakers should avoid immediate contractionary responses like interest rate hikes, as energy shocks are initially inflationary but subsequently deflationary.

Key Decisions for Investors

• Investors should intensify monitoring of geopolitical developments in the Middle East, particularly any signals of US military action or threats to the Strait of Hormuz, as these are primary catalysts for oil price volatility.
• A thorough review of portfolio exposure to energy markets and related sectors is warranted, considering scenario analysis for oil prices potentially exceeding $100 per barrel against the current market complacency.
• Prepare for heightened market volatility across asset classes and reassess inflation and growth forecasts, as an escalation could significantly alter central bank policy trajectories despite cautionary advice against premature tightening.
• Given the 'moderately negative' sentiment, 'cautious' tone, and the market's current optimistic assumptions regarding containment, consider implementing or reinforcing hedging strategies against tail risks associated with a wider, unexpected conflict.