The Middle East conflict - some observations

The conflict in the Middle East escalated last week with strikes on energy facilities, energy prices hitting new highs and sharp declines in equity markets. On Friday, president Donald Trump said he is considering “winding down” the conflict but Iran has stepped up offensive operations with an attempted missile strike on the UK-US base on Diego Garcia, 4,000 kms from Iran, and strikes on two towns close to a nuclear facility in southern Israel.

The resolution of this conflict remains as uncertain today as it was just over three weeks ago, when it started. Stepping back from the myriad uncertainties, here are eight observations on the conflict.

1. Despite more than three weeks of aerial bombardment, Iran is still able to cause enormous disruption to global energy markets, generating what Fatih Birol, the head of the International Energy Agency, last week called “the gravest energy shock of all time”. Iran is launching far fewer missiles and drones than at the start of the war, but, in response to Israel’s attack on Iran’s main gas field last Wednesday, it has targeted energy infrastructure across the Gulf and struck the world’s largest LNG processing terminal in Qatar. Iran has also succeeded in all but closing the Strait of Hormuz, something it has often threatened over the last 45 years but never previously achieved. Mr Trump may want to wind down the war. It is not clear that Iran does.
2. Even if the conflict ended tomorrow, the disruption and damage to energy supplies mean higher inflation in Europe and, to a lesser extent, the US. Last week, the Bank of England signalled that UK inflation could be running at around 3.0% in the second quarter, up from a forecast 2.1% last month. The new forecast predated the surge in energy prices late last week caused by strikes on energy infrastructure. Markets think the Bank of England will raise base rates by about 75bp this year, a volte-face from the 50bp of rate cuts priced in at the start of this year.
3. UK government bonds are on the sharp end of a global sell-off. The prospect of higher inflation and, potentially, subsidies for energy users, has sent a chill through government bond markets. UK bonds have suffered the biggest losses, largely because Britain’s dependence on imported gas amplifies inflation risk. On Friday, UK ten-year bond yields hit 5.0%, the highest level since 2008.
4. It will be harder for governments to support consumers and businesses through this energy shock than the last one, in 2022–23. Then, governments borrowed on an enormous scale to shield consumers and private businesses from the full effect of higher energy prices. UK energy subsidies alone cost over £40bn. Governments today are more constrained by high borrowing costs and high levels of debt.
5. Global growth will be weaker, with the US relatively well placed and Asia, by dint of its reliance on Middle Eastern energy, most exposed. Europe is somewhere in between. We expect to see a raft of downgrades to growth forecasts over the coming weeks.
6. The conflict reinforces the need for more varied, secure and affordable sources of energy, strengthening the case for indigenous capacity whether nuclear, renewables or hydrocarbons. Soaring energy prices have led some to argue that the UK government should reverse its decision to issue no further licences for drilling in the North Sea.
7. The conflict in the Middle East has added new strains to US-Europe relations and comes after recent disagreements over military spending, support for Ukraine and Greenland. The pressure for Europe to rearm and reduce its reliance on US military capabilities keeps growing.
8. Russia appears to be gaining from the conflict. It benefits from higher energy prices, frictions in Europe’s relationship with the US, a diversion of US military efforts and attention, and the world’s focus, away from Ukraine.