Since the advent of the Covid-19 pandemic in 2020 we have been hit by a series of rare events, often unexpectedly, with a huge impact on and consequence for societies, economies and markets.
These have ranged from Russia-Ukraine, Israel-Palestine and now the US-Israel-Iran conflict. This has largely stemmed from rising populism and nationalism, which have also affected economic policies. These have become increasingly protectionist, resulting in events such as the US-China trade wars, Brexit, “Liberation Day” in the US, tensions in global trade and rising tariffs. The frequency has risen and though the impact and consequences remain high we no longer consider these black swans.
In the most recent set of events the Iran conflict has direct and material implications for global oil supply. The Middle East remains central to the world’s energy system, with countries involved in this conflict, including the US, accounting for more than 60% of global oil production. About 20%-30% of global oil supply transitions through the Strait of Hormuz, a narrow stretch between Iran and the United Arab Emirates. Top producers are clustered around the Gulf, with Iran itself contributing 10% of oil cartel Opec’s production and about 4% of global production.
While the global oil supply has not yet been materially curtailed, the persistence of elevated tensions increases the likelihood of sustained price pressure, which could feed through to inflation expectations and energy-sensitive sectors across the global economy.
Brent crude prices have risen above $80/barrel from about $60 at the start of the year, a more than 30% year-to-date rise. Should these tensions persist for an extended period and global oil prices remain at present levels or rise further, it will feed through to global inflation through high fuel, transport and production costs of goods and services.
This, with higher tariffs, could induce a stagflationary environment in which inflation rises while growth slows, pressuring consumers and making it difficult for policymakers to keep inflation under control while attempting to support economic growth.
However, the severity of the crisis will depend on the duration of the conflict and how much supply will be disrupted, both of which remain uncertain.
Brent crude futures markets are in backwardation, indicating that future prices are expected to be lower than now. Ignoring the cost of carry and the convenience yield, Brent crude prices could drop below $70 by year-end — indicating a short-term view of these events by market participants.
Overall, the response from energy markets has not been as extreme as in the Russia-Ukraine war, in which Brent crude prices rose to more than $130 and inflation in developed economies rose to double-digits, resulting in a tight monetary policy regime globally and excessive market drawdowns. Despite this softer response by markets, events in the Iran crisis are still unfolding.
In response to these events, global equity markets started the week on the back foot, with airline counters pulling back the most. In contrast, the energy and defence sectors gained due to rising earnings expectations. Safe haven assets such as gold have continued to surge due to these heightened tensions as investors price in greater geopolitical risks. There have been some reversals in declines in European stocks after reports that Iran mentioned it is ready to get rid of its stockpile of enriched uranium during nuclear negotiations with the US.
From an investment strategy perspective, history has consistently shown that markets move through cycles, with bull market periods outperforming and outlasting bear market periods and the resultant drawdowns. Investors’ attempts to time the market often results in missed opportunities, particularly during the early stages of recovery when returns can be strongest.
• Smith is chief investment officer at Absa Investments.