Global markets have grown accustomed to the US president’s posturing over the past year, but economists caution that investors may be
“a little bit complacent”in expecting a brief conflict in the Middle East.
Over the past year, investors have observed that Donald Trump has an extensive capacity to swiftly reverse decisions under intense political or market pressure.
However, one week after the United States and Israel initiated missile strikes on Iran, concerns have emerged that the conflict could evolve into a prolonged war.
Economically, the war has triggered what has long been considered a worst-case scenario for Middle Eastern conflicts: disruption of the Strait of Hormuz, a critical passage through which one-fifth of the world’s oil and gas supplies transit.
Since hostilities began, the global benchmark oil price has surged 17% to over US$85 per barrel, sending shockwaves through financial markets.
Although the Australian sharemarket has been relatively insulated from the worst effects, it still experienced a steep 3.8% decline over the week.
Asian markets, especially those in countries heavily dependent on imported energy, suffered significant losses.
South Korea’s stock market fell 13% in a single session, marking its worst day in history.
Meanwhile, on Wall Street, the S&P 500 index declined by less than 1% heading into its final session on Friday night.
Just another shock
As the Trump administration considered deploying America’s strategic oil reserve on Friday to alleviate price pressures, Shane Oliver, chief economist at AMP, expressed concern that
“markets are a little bit complacent.”
“The mildness of the response has surprised me,”Oliver said.
“And that partly reflects the experience of the past year or so with Trump, where there have been numerous shocks – especially around American tariff announcements – and then we get some sort of backdown.
Markets are assuming there will be some sort of backdown and this won’t be a long, drawn-out war.”
The fundamental challenge for investors is the uncertainty surrounding Trump’s rationale for initiating the conflict and what conditions might lead to its resolution.
This uncertainty has left markets in a holding pattern, pricing in a sharp but relatively brief conflict lasting two to three weeks rather than several months.
While this is a high-risk assumption, it remains a defensible position.
The Australian dollar’s maintenance above 70 US cents reflects the relatively calm market response to what is being termed the third Gulf War.
Ray Attrill, head of foreign exchange strategy at National Australia Bank, noted that the Australian dollar’s resilience partly stems from Australia’s status as a major energy exporter through its LNG and coal resources.
“With oil prices in the 80s, the underlying assumption is that oil will start travelling through the Strait of Hormuz sooner rather than later, and the big disruption will not last too long,”Attrill said.
Derivatives market bets suggest oil prices will return to the US$60s or US$70s within a month.
However, Attrill warned that a larger and more prolonged shock would cause the Australian dollar to decline significantly.
“If that assumption starts to get challenged, then oil at US$90 or US$100 starts to become very viable. And in that environment, there would be a much deeper sell-off.”
Oil’s stagflationary impact
An oil price shock is stagflationary, as higher fuel costs increase inflation while simultaneously hindering economic growth.
This dynamic places central bankers in a difficult position: whether to raise interest rates to control inflation or to ease monetary policy to support economic growth.
This situation differs from the 1970s, when a doubling of oil prices drove inflation and unemployment in Australia into double digits.
Nevertheless, there have been and will continue to be economic impacts.
Jim Chalmers warned this week of the potential for
“substantial”consequences on both the local and global economies resulting from the war.
Currently, attention is focused on the implications of higher oil prices for inflation and interest rates.
Economists at NAB estimate that inflation is now likely to peak at approximately 4.75% in the year to June, about half a percentage point higher than forecasts made before the Iran conflict began.
This estimate assumes Brent crude prices remain near current levels.
A sustained increase to US$100 per barrel could push inflation above 5%, reaching its highest level since late 2023.
These figures underscore why investors, central bankers, and politicians worldwide are closely monitoring oil prices.
Reserve Bank governor Michele Bullock emphasized her awareness of the risk that
“inflation expectations might become a little bit unanchored,”which could complicate efforts to reduce price pressures.
While the RBA typically looks beyond temporary price shocks, Bullock indicated that this situation might be more challenging.
“This one might be a little bit harder, because … we already have elevated inflation, and I think there is a risk that inflation expectations might become a little bit unanchored,”she said.
This time could be different
Brett Solomon, senior portfolio manager in QIC’s fixed income team, observed that investors have grown accustomed to geopolitical uncertainty in recent years but cautioned that this conflict could be different.
“Over the last few years investors have seen geopolitical headlines only last for a week. We’ve seen that many, many times. So we’ve become accustomed to that,”Solomon said.
“What is different this time is that this could be longer lasting, and that could be a really big difference.”
Solomon currently maintains the view that the RBA will implement one more rate hike in May.
However, like other investors, he will monitor whether oil prices remain elevated enough and for long enough to prompt central bankers and investors to reassess their positions fundamentally.
Kerry Craig, global market strategist at JP Morgan, stated that
“the base case for most hasn’t changed: that this won’t be something that drags on for months, and the outlook for the global economy is fairly decent.”
“Really when you change that view, it’s because you think we are now heading towards recessions.”
Patrick Commins is Australia’s economics editor.
