If you read the financial news this week you will see that everyone is talking about interest-rate cuts. The most prominent discussion on this topic is in the US, in the run-up to the election. Supporters of the Democratic Party have been crying out for the US Federal Reserve to lower interest rates, and at the end of September, the Fed obliged, handing the incumbent party a large 0.5% decrease in borrowing rates. Whether this will feed through to the economy by election day is doubtful, but it certainly gives those looking to take out mortgages in the near future some economic hope.
Now “lower-rate fever” is spreading to Europe. In this case, politics are not playing a leading role in the debate. Rather, technocrats and investors want to get back to what used to be called the “new normal”, but which is starting to feel like the old normal: stagnation, permanently low rates, and occasional bouts of monetary easing. Clearly both the technocrats and market participants have realised over the past few years that although economic stagnation and low rates might not be optimal, they are preferable to economic stagnation, inflation and interest rate hikes.
What will happen to interest rates?
Investors are now talking openly about interest rates in Europe halving by this time next year, falling from 3.5% to 1.75%. This follows from the annual rate of European consumer price inflation falling from 2.2% in August to 1.8% in September, meaning that for the first time since June 2021, inflation in Europe has been below the European Central Bank’s 2% target.
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The broader economic backdrop looks grim for Europe too, with Citi Group’s economic surprise indicator being underwater since the summer (negative surprises in the data are outweighing positive ones); investors do not have very high hopes for Europe’s economy now, but the data is disappointing even those inclined to low spirits.
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But this could be an instance of investors being lulled into a false sense of security. Just as market watchers are eager to get back to the old-new normal of low interest rates and stagnation, they want to put the geopolitical shocks that caused the recent inflation – namely, the Covid lockdowns and the Russia-Ukraine war – behind them. Yet when we turn the page of the newspaper from the economy to foreign affairs, we see that the Middle East is a tinderbox – a single spark could set it off. As the Scottish poet Robert Burns once observed, the best-laid plans of mice and men can often go awry – and he could well have been referring to those who are hoping our economies settle back into a sadly stagnant, but uneventful, calm.
Impact of a wider Middle East conflict on global markets
The increased risks have been there in the Middle East since Hamas launched its attack on Israel on 7 October last year. The response from the Israeli government immediately signalled that it was not willing simply to return to business as usual; it was committed to the eradication of Hamas. At the time, those following the situation closely noted that Hezbollah, an ally of Hamas based in Lebanon, to the north, was also engaged in a campaign against Israel, one that has resulted in the Israeli government evacuating 60,000 people from their homes in northern Israel. This situation was clearly intolerable to the Israelis and led many to suspect it would result in a war against Hezbollah, a war that we are now seeing the beginnings of.
Markets had been dismissing these risks for months. They had been banking on the idea that the conflict would remain contained. In effect, that means they had been relying on the assumption that Israel would merely continue its campaign against Hamas and would not expand the front to the north. However, Israel did open a northern front and, shortly after, we gained a sense of why this risked escalation to a regional war: in response to the assassination by Israel of Hezbollah leader Hassan Nasrallah, Iran – an ally of the group – launched a large missile strike against Israel in early October.
Unless one side backs down, the situation in the Middle East now looks ripe for continuous escalation, with one fighting force hitting the other, and the other responding in kind. It is no longer tenable for markets to ignore this risk, and since the Middle East is central to global energy markets, investors need to be realistic about the potential for another round of inflation driven by yet another energy shock. We are already starting to see price action in this direction in the oil market with the price for Brent having recently risen from a low of $70 a barrel in early September to $80 a barrel just after the Iranian strike – although it has since fallen back.
How important is the Middle East to global energy markets?
The region accounts for approximately 18% of global gas production. Since the outbreak of the Russia-Ukraine war and the consequent disruptions, this has made the region a more important player in the European liquefied natural gas (LNG) market. But it is still the production and export of crude oil where the Middle East excels: the region comprises 32% of global production and has 40% of the world’s proven oil reserves.
Five of the ten top oil producers are in the Middle East: Saudi Arabia, Iraq, Iran, the United Arab Emirates and Kuwait. What is more, these countries have a much larger impact on the global oil price than larger producers, like the US. The reason for this is that while the US produces large amounts of oil, it consumes even more. Middle Eastern countries, however, typically produce much more oil than they consume.
Even though the US is the largest oil producer in the world, its net oil output – oil production minus oil consumption – is around minus 6.7 million barrels per day, meaning the country runs a large crude oil deficit. Net oil production in Saudi Arabia, on the other hand, is 4.5 million barrels a day.
From “destabilising” to “catastrophic”
How might this oil production be affected by conflict in the Middle East? The scenarios here range from “destabilising” right up to “catastrophic”, depending on what takes place in the coming weeks and months. A destabilising series of events would unfold something like this: Israel would respond to Iran’s strike with a counterstrike on Iran’s energy infrastructure, which would in turn prompt Iran to respond to Israel.
This might then result in instability or strikes in other countries like Iraq and Syria. In this scenario, around 10.4% of global oil production would be at risk. Of course, not all 10.4% would be taken offline, but even if only a quarter of this output was removed from markets there could be a large impact on prices.
The nightmare scenario – the truly catastrophic event – would be if the strikes and counterstrikes eventually gave way to a regional war in the Middle East involving Israel, possibly the US, and Iran, plus its proxies in the region. If this war reached any serious level of intensity there is a serious risk that the Iranians would use anti-shipping ballistic missiles to blockade the Strait of Hormuz, much as the Houthis have recently blockaded the Red Sea entrance to the Suez Canal. Around 20%-30% of global oil production is shipped through the Strait of Hormuz and a closure, together with a regional war, could knock out a significant part of this capacity.
The last time we saw a significant hit to global oil production was after the Iranian Revolution in 1979 and the Iran-Iraq War that followed. Between 1979 and 1983 global oil production fell approximately 17%. As production started to crater, the markets priced it in quickly: between 1979 and 1980 the price of oil nearly tripled. We saw a similar move in the oil price in response to the oil embargo by Opec, the oil exporters’ cartel, against Western countries in 1973 after they backed Israel in its war with the Arab countries.
The impact on consumer prices
What would a tripling of the price of oil mean today? First, it would mean a rise in the oil price to around $210 a barrel. This would mean the most expensive oil the world has ever seen, at least in dollar terms; $210-a-barrel oil would be around 58% higher than the historic peak we have seen so far – $133 a barrel in the summer of 2008. Even if a major decline in oil output did not lead to shortages, it is inevitable that such high oil prices would lead to inflation.
The link between oil prices and inflation is quite firm, with oil price fluctuations often accounting for a good deal of the volatility we see in inflation. This allows us to model the impact that $210-a-barrel oil would have on the inflation rate. The result of this model is by no means perfect, but it is almost certain to be in the right ballpark.
$210-a-barrel oil means inflation of around 18% in the US and 19% in the UK. Despite the high and painful inflation of the past few years, we never saw the inflation rate break 10% in either country. If our model is in the right ballpark, a crisis in the Middle East would mean roughly double the inflation that we have seen over the past few years. The impact of such inflation on living standards in Western countries – already reeling from the last cost-of-living crisis – would be enormous.
Gauging the probabilities
What are the chances of this happening? It depends mostly on what the Israeli government chooses to do next. If it responds to the previous Iranian strike in a measured way, the situation might cool off – although even in this scenario, it is worth noting that while the conflict has ebbed and flowed over the past year, the general trend has been toward escalation. If Israel responds by hitting Iranian energy and nuclear facilities, then at the very least we will see the conflict spread across the region. Whether it becomes a regional war at that point likely hinges on what the US decides to do.
This is where the election comes in. In the run-up to the election itself, Joe Biden’s administration is likely to constrain itself – and its Israeli partners, as best it can. But after the election, it is anyone’s guess. If Donald Trump wins, for example, the Biden administration may give Israel the go-ahead to escalate knowing that the economic consequences will fall on the incoming Trump administration – a government generally seen as more favourable to Israel than the Biden administration. If Kamala Harris wins, it will be strongly in the Democrats’ interest to keep the situation from boiling over. Ultimately, however, trying to guess what the White House will do is as fruitless as the Kremlinology common in the Cold War period. We will just have to wait and see.
Black gold: hedging against inflation
What are investors to do? This is certainly one of those scenarios where there is little point in trying to predict the future. If an investor is concerned that their portfolio might experience a negative shock from such a global event, the ideal is to find a series of relatively cheap hedges that might offset this.
In this context “cheap” simply means assets that are not likely to fall too much if nothing happens in the Middle East. These assets provide significant upside risk in the case of chaos breaking out and minimal downside risk in the case where nothing happens.
The most obvious cheap asset in this regard is oil itself. Despite all the chaos, and even despite the upward moves in recent weeks, the price of oil is surprisingly low at present. The previous oil price shock had largely unwound by the start of 2023. Since then, the average price has been approximately $78 a barrel. Anything under $78 a barrel should be considered cheap. The longer-term average oil price since 2009 is around $71.50 a barrel and anything under this should be considered very cheap. Buying oil cheap minimises the downside risk of losing money if nothing happens.
Then there is gold. In contrast to oil, gold is not currently cheap. At close to $2,650 an ounce, gold is the most expensive that it has ever been. Yet there is good reason to think that the shiny metal is not in a bubble. Until quite recently the gold price could be shown to track inflation data quite reliably. But in the past few years, it has found a second driver: purchases by central banks. Rattled by the sanctions imposed on Russia’s dollar and euro foreign-exchange holdings after the war, central banks are rushing to buy gold, and this is driving the price up.
It seems reasonable to think that if the Middle East falls into chaos, central banks will double down on this bet. And if high oil prices feed into inflation, this could give gold a double boost. Purely based on price, gold does look very expensive – and investors should weigh this risk carefully. But the drivers of the price suggest that gold is on the up and up, regardless of what happens in the Middle East. Whereas buying oil now is like buying a stock with low multiples, opting for gold right now is like buying a popular growth stock with strong fundamentals.
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