Investors are expecting Donald Trump to back down in the war with Iran – but what if he doesn’t? | Australian economy
Over the past year, investors have learned that Donald Trump has an unlimited capacity to quickly reverse course in the face of severe political or market pressures.
But a week after the US and Israel launched missile attacks on Iran, there are fears the war could escalate into a protracted conflict.
From a purely economic perspective, the war brought about what has long been considered the worst-case scenario for a conflict in the Middle East: the closure of the Strait of Hormuz, through which one-fifth of the world’s oil and gas supplies pass.
Since the start of the conflict, the global benchmark oil price has risen by 17% to over US$85 per barrel, triggering shockwaves in financial markets.
The Australian share market was relatively spared from the worst of the negative impact but still lost a steep 3.8% for the week.
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Asian markets, many of which are in countries heavily dependent on imported energy, have been hit.
The stock market in South Korea recorded the worst day in its history, crashing by 13 percent in a single session.
However, on Wall Street, the S&P 500 index entered its final session Friday night with a loss of less than 1%.
Another shock
On Friday, as the Trump administration considered using America’s strategic oil reserves to ease pressure on prices, AMP chief economist Shane Oliver said he was concerned “markets are a little complacent.”
“I was surprised by the gentleness of the response,” Oliver said.
“And that partly reflects our experience last year with Trump, where there were a lot of shocks, especially around America’s tariff announcements, and then we kind of backtracked.
“Markets are assuming there will be some kind of downturn and that it won’t be a long, protracted war.”
The real challenge for investors is that it is not clear why Trump decided to start the war and therefore what it will take to end it.
This has left markets in a holding pattern: priced in for a sharp but relatively short conflict that will last another two to three weeks, but not months.
It’s a high-risk bet, but a defensible one.
The fact that the Australian dollar remains above 70 US cents is evidence of the relatively optimistic response to the so-called Third Gulf War.
Ray Attrill, head of foreign exchange strategy at National Australia Bank, said the Australian dollar’s resilience partly reflected the fact that Australia was a major energy exporter through its LNG and coal resources.
“With oil prices in the 80s, the basic assumption is that oil will start moving through the Strait of Hormuz sooner or later and the major disruption won’t last too long,” Attrill said.
Bets placed in derivatives markets suggest oil prices will return to $60 or $70 within a month.
But Attrill said a much larger and longer-lasting shock would send the dollar much lower.
“If that assumption starts to be questioned, then oil starts to become very affordable at $90 or $100. And in that environment, there’s going to be a much deeper sell-off.”
Stagflationary effect of oil
An oil price shock is stagflationary because higher fuel costs hurt growth while increasing inflation.
It’s a dynamic that puts central bankers in a quandary: Raise interest rates to control inflation, or ease monetary policy to support the economy?
This is not the 1970s, when the price of oil doubled causing inflation and unemployment in Australia to reach double digits.
This does not mean that there is not and will not be any effect.
Jim Chalmers this week warned of the potential for “significant” consequences for the local and global economy as a result of the war.
For now, the focus is on what higher oil prices mean for inflation and interest rates.
NAB economists predict inflation will reach around 4.75% by June, half a percentage point higher than predicted before the start of the Iran war.
This means Brent crude oil prices are at current levels.
They calculate that a sustained move towards $100 per barrel could push inflation above 5 percent, the highest since late 2023.
Figures like these show why investors, central bankers and politicians around the world are so focused on the price of oil.
Federal Reserve Governor Michele Bullock made clear on Tuesday that he was alert to the risk that rising oil prices could strengthen views that inflation will remain high for longer, which could make it harder to get price pressures back under control.
The RBA generally ignores temporary price shocks but Bullock said it was not clear that was the right approach.
“That might be a little bit more difficult because … we already have high inflation and I think there’s a risk that inflation expectations will become a little bit unbalanced,” he said.
It might be different this time
Brett Solomon, senior portfolio manager in QIC’s fixed income team, said investors had become accustomed to geopolitical uncertainty in recent years, but this time could be different.
“Over the last few years, investors have seen geopolitical headlines last only one week. We’ve seen that many times. So we’ve gotten used to it,” Solomon said.
“What’s different this time is that it can last longer and that can be a really big difference.”
For now, Solomon said he remains of the view that the RBA will raise interest rates once again in May.
But like other investors, he will watch to see whether oil prices move high long enough to trigger central bankers and investors to fundamentally reassess their positions.
Kerry Craig, global market strategist at JP Morgan, said “the fundamental case for most remains unchanged: this is not going to be something that lasts for months, and the outlook for the global economy is pretty good.”
“When you actually change that perspective, it’s because you now think we’re headed for a recession.”
