• The risk of a broader conflict in the Middle East is rising
• Escalation of the conflict could send crude prices sharply higher
• Higher oil prices and inflation threaten global economic recovery

Stock markets have been trading higher since October 2022 assuming a soft landing for the global economy, lower inflation, and falling interest rates. The war in Gaza has deepened the crisis in the Middle East with tensions rising over the past weekend. The retaliatory attack of Iran against Israel marks a clear escalation of tensions in the region, threatening to turn into a regional war.

The developments over the weekend are considered as a significant deterioration in the geo-political situation in the Middle East, and further escalation would have severe impact on the global economy and financial markets.

Escalation of the Middle East Crisis Could Push Oil Prices Higher

An escalating conflict in the Middle East could cause a surge in oil prices, which in turn could trigger a surge in inflation, a turmoil in global equity markets, dampened business confidence, and reduced investment activity.

Iran is a significant oil player ranking as the seventh largest crude oil producer accounting for 4% of global oil production. The country is the third largest natural gas producer with roughly 6% of global output. ^[1]

But apart from a potential disruption in Iranian oil exports, the bigger risk is the potential of the conflict spreading into the region as the Middle East accounts for more than 30% of global oil output.

Additionally, the risk of transit disruption is huge. Routes like the Strait of Hormuz is used for roughly 20% of global oil supply, as almost 10 billion cubic feet of liquified natural gas travels there every day. ^[2]

As such, significant escalation of the conflict in the region could push crude prices to their 2022 highs, which is more than 50% higher from current price levels. Spikes to the previous highs are likely to be short-lived; however, crude prices could remain elevated for several months.

For the moment, the possibility of escalation of the conflict remains contained and crude prices have been declining over the past few trading sessions. Also, Iran and other countries in the region rely on the Strait of Hormuz, which makes its closure less likely. In the event of closure, non-OPEC producers are likely to ramp up production and mitigate to some extent the impact. Higher crude prices would lower demand, which would also prevent oil prices staying at record levels for extended period of time.

Geo-political tensions Could Spoil the Global Economic Recovery

One of the potential consequences of escalation of the conflict in the Middle East are to see substantially higher oil prices. The looming threat of higher energy prices could trigger a spike in inflation globally and disrupt the optimism in financial markets.

Such scenario would delay interest rate cuts, or even force central banks to hike rates in order to contain inflation. Higher interest rates would have adverse impact on global economic growth and unless there is a clear trend of inflation sustainably moving higher, central banks are likely to refrain from rate hikes. Our base line scenario is that central banks would keep rates higher for longer, rather than hiking again, in order to prevent their economies falling into a recession.

Therefore, we see higher crude prices as one of the biggest risks to the current global economic recovery. Crude prices rising above $110 would be considered as an immediate threat, which could derail the global economic recovery.

Higher crude prices have different impact on inflation across regions. Energy independent countries such as the United States, Canada and Australia are likely to be less impacted; however, for European nations the impact is likely to be much larger.

Another point for consideration is that many countries are less energy intensive than in the past, therefore the impact of higher crude prices to inflation would likely be less severe than in the 1970’s.

Source: TradingView

Stock Market Reaction

Investors optimism has driven financial markets substantially higher since October 2023, amid robust labour market, strong consumer, investor confidence that inflation is moderating and that central banks will start to ease monetary policy in 2024.

Recent pick up in U.S. inflation, which lead to an uncertainty regarding the timing and magnitude of rate hikes by the Federal Reserve this year, alongside anxiety over the Middle East crisis have driven down the S&P 500 by 5% from the beginning of April.

The potential escalation of the conflict poses threats to economic stability, particularly concerning oil production and shipping lanes control. As long as critical energy supplies remain undisrupted, oil markets are expected to remain stable and stock markets are likely to resume their upward trajectories.

However, should the conflict escalate further, global equity markets would face a significant downside risk and we see potential declines of at least 20% from current levels.

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1. IEA / Country Analysis Executive Summary: Iran
2. IEA / The Strait of Hormuz is the world’s most important oil transit chokepoint