Iran remained very much centre stage last week with dramatic moves in the oil price. The price of Brent crude surged to a high of $115/bbl early in the week, before falling back to $85 and then moving back up to its current level of $105. This compares with around $70 before the crisis erupted and the high of $120-130 seen in 2022.
Bonds and equities echoed these gyrations in energy prices but on a much smaller scale. Global equities ended the week down 0.9% in local currency terms. In sterling terms, markets were down 1.4%, leaving them off 3.7% from their February high but still up a slight 0.4% year-to-date.
China and the UK fared best last week, with China actually up 1.2% in sterling terms and the UK down a modest 0.2%. The US and Europe were both down 0.7% while emerging markets and Japan lost 1.1% and 3.4% respectively. Energy stocks were once again the only sector to post a gain.
Bonds also posted losses, with yields rising 0.1-0.2% as hopes of rate cuts faded in the US and fears of a rise in rates grew in the UK and Europe. Gilts lost 1.1% while US Treasuries were down 0.8%. The 10-year UK gilt yield is currently 4.8%, up 0.5% from its February low and 0.25% since the start of the year. Lastly, gold fell 2% or so slipping back to around the $5000/oz mark and the dollar strengthened a little further.
Market moves are being dictated by the rapid shifts in expectations over how long the war will last and more importantly how long the Strait of Hormuz will stay closed. Trump’s comments about the aims and likely duration of the war change on a daily basis and have been a major factor here. However, the belief has generally grown that the Strait could remain closed for a month or two, more than was thought initially, with a significant risk that it could remain blocked for longer still.
The apparent ability of Iran to continue attacking shipping via drones and potentially mines, even if its missile capabilities have been severely degraded, is behind this shift. So too is the realisation that although the pressure on Trump to seek a quick end to the war is growing, not least because of the surge in US gasoline prices, Iran has to be party to any agreement and as yet is showing no sign of capitulating.
Still, the US is planning to try and escort shipping safely through the Strait and is now calling for both its Nato allies and China to help in these efforts. There are also attempts underway by India and some European countries to negotiate safe passage with Iran. All said and done, how long the Strait stays closed remains very much the key question and is still very unclear.
In the meantime, the G7 has poured some oil on troubled waters and agreed to release 400m barrels of oil from the IEA’s strategic reserve of 1.2bn barrels. By way of comparison, some 20mn barrels per day usually pass through the Strait of Hormuz.
The surge in oil prices is taking its toll on economic projections for the coming year with inflation forecasts being raised and growth forecasts cut. Assuming the Strait doesn’t remain closed for more than a month or two and that oil prices are back down to $70-80 later in the year, the revisions are significant but far from disastrous.
Forecasts for headline inflation have generally been raised by 0.5-1% later this year. In the US, the headline rate now looks likely to head up to around 3.5% over coming months from 2.8% in January. However, the boost to core inflation, which is currently 3.1% and much more a focus for the Fed, should be no more than 0.25% or so. The increase should be limited by the relatively weak state of the labour market – unlike in 2022 when the oil-related surge in inflation proved not half as transitory as had been expected.
Here in the UK, inflation looks set to head back up to 2.5-3% later this year, rather than fall to the 2% target as had been on the cards. The inflationary impact should be delayed/reduced by the energy price cap which is in place until the end of June and probably additional action by the Government.
As for the impact on activity, growth forecasts are being revised down by 0.25-0.5% , a bit more so in the UK and Europe than in the US as the latter is shielded to some extent by not being a net importer of energy. This should cut growth to around 1% in the UK and Europe and 2% in the US.
The latest data on the state of play going into the war were mixed. US growth in the fourth quarter was revised down to a meagre 0.7% annualised rate but was depressed in part by the government shutdown. Growth should recover this quarter and next on the back of a government rebound and personal tax cuts which are now starting to flow through.
UK GDP also disappointed in January. Activity was flat despite the marked pick-up in business confidence seen earlier this year. More encouragingly, the crop of numbers out this morning in China for retail sales, industrial production and investment in January/February all surprised on the upside.
For central bankers, the boost to inflation should outweigh the reduction in growth and leave them inclined to keep policy tighter than otherwise. In the case of the US, this will very likely limit and delay the rate cuts previously on the cards; rates are now expected not to be reduced until the summer/autumn and most likely only by 0.25% rather than 0.5%.
In the UK, the market is now actually pencilling in the possibility of a 0.25% rise in rates later this year, rather than the one or two cuts which had been expected. More likely, the crisis will just keep the Bank of England on hold.
As for the Eurozone, the market is pricing in two 0.25% hikes by year-end. Again, this looks like a bit of an overreaction and any tightening is likely to be confined to just one move.
Even though the surge in oil prices now looks set to continue for somewhat longer, we still believe the view outlined last week broadly holds good. While markets could well come under further pressure while the Strait remains closed – given the limited size of the falls seen so far – the macro backdrop should remain positive enough to allow them subsequently to recoup their losses.
In essence, we still believe the playbook for the vast majority of previous geo-political crises/wars, where market declines were limited and short lived and followed by rapid rebounds, will most likely play out this time too.
This week, Iran will clearly remain centre stage. But so too will be the Fed meeting on Wednesday, BOE and ECB meetings on Thursday and BOJ meeting on Friday. All are certain to leave rates unchanged. Rather, the attention will be on their comments on the impact of the war on growth, inflation and the prospects for interest rates.
Rupert Thompson – Economist