Conflict in Iran: how long will it last, and what will be the economic impact?

Luke Bartholomew:

Hello and welcome to Macro Bytes, the economics and politics podcast from Aberdeen. My name is Luke Bartholomew.

Paul Diggle:

I'm Paul Diggle.

Lizzy Galbraith:

And I'm Lizzy Galbraith.

Luke Bartholomew:

And this week we are talking about the conflict in Iran, I guess the wider Middle East. And that is, of course, a very fast-moving situation. We are recording on Wednesday, the 4th of March. So by the time you are listening to this, much could have already changed. So on that basis, we will try to focus less on reporting events and maybe take a step back a little bit and think about questions like US and Israeli strategy, Iran's reaction function, what kind of outcome market prices seem to be discounting, what the risks are both to the upside and downside, and how to think about the economic implications of this conflict as well. So Lizzy, why don't you start us off by outlining what we know about America and Israel's war aims, both in terms of statements from policymakers, what they've said, but also from a revealed preferences perspective, you know, is there anything we can infer from their actions as well? You know, what is it that they want from this conflict?

Lizzy Galbraith:

So I think it's fair to say that some of these have shifted somewhat over the course of the conflict, certainly related from, let's say now to a few weeks ago when it certainly looked like we were heading towards something, not necessarily sure about what the scale of that something was, but the US articulation of what it was concerned about has certainly shifted, I think, between then and now. But in terms of what US war aims are as articulated currently, that would be degradation of Iranian ballistic missile and nuclear capabilities, the destruction of the Iranian navy and an end to Iran's sponsorship of regional proxies. Now, it's worth noting, when we're talking about the US's war aims here, that Israel seems to have a slightly different articulation of its own goals for the conflict. It encompasses all those US aims I just mentioned, but they also seem to be a little bit more explicit when it comes to thinking about the potential for regime change here, or at least very significant weakening of the current regime and any successor to it. So there may well be a slightly more maximalist goal there on the part of the Israelis versus the US. But actually, in practical terms, there doesn't seem to be too much daylight there. So it could well be a rhetorical rather than practical difference there. Certainly, President Trump has made repeated comments encouraging dissent against the regime within Iran. And there are reports that the US has been considering supporting other groups across the region to help destabilize the regime. So in practical terms, there appears to be far less difference than possibly rhetorically speaking.

Luke Bartholomew:

And are those realistic goals?

Lizzy Galbraith: Maybe, but the risk of unintended consequences here is very, very high. So with regards to degrading nuclear and military capabilities, the US is probably broadly able to do that. And it's worth noting that those are similar goals to the 12-day war last year, where the US effectively declared job done after a fairly short conflict, which weakened Iran substantially, but crucially didn't lead to any policy change from the regime. They've built back those stocks. Indeed, the US key accusation here is that Iran was intending on going further since then. So it's possible that the US does a similar thing again, that it, you know, it credibly degrades those nuclear and military capabilities, it then declares job done. And that could be a viable way to end this conflict, particularly if the US wants to end its combat role quickly. It doesn't necessarily need to prove that some of these, some of these assets are permanently gone for it to be able to say that it has degraded them such that the threat is sufficiently reduced. But regime change itself is far, far harder to achieve. So if that is part of the actual war aims that we see going forward, then that is potentially a far more drawn out, far more complex set of goals that could have far more far-reaching consequences that may be beyond the gift of any one actor, either regionally or globally, to control.

Luke Bartholomew:

And Paul, as Lizzy has said, I mean, for several weeks now, it looked like we were heading towards something. US military strikes on Iran were predictable and indeed predicted. But perhaps the big surprise so far in this conflict has been Iran's response, which I think it's fair to say has been much larger and more dramatic than expected, certainly compared to, say, the 12-days war that we've talked about. So what do you think is the strategy or the reason behind Iran's response being like this?

Paul Diggle:

Yeah, we had written about just last week in some of our research at Aberdeen that Iran had multiple retaliatory vectors, which would make the escalation of this conflict very different to, say, any risks that there were about Venezuela, for example. And that in the event that regime, the Iranian regime, perceive this as an existential threat, which it absolutely does, then that response function would be much wider than, say, during the Israel-Iran 12-day war that the US then joined as well. So I think it's as much if not more about trying to restrict Middle East oil flows, inflict economic and civilian pain across the Gulf allies of the US, as it is about launching long-range missile attacks at Israel. So we've seen things like multiple ships hit in the Strait of Hormuz. That's, of course, where a fifth of global oil supply flows throughout the Persian Gulf. The Strait is effectively closed as of this recording, but for a trickle of tankers getting through to China. And we've seen these strikes on hotels, airports, major oil and gas refining and export facilities, civilian infrastructure across the Gulf, forcing the closure of many of those facilities. And I think importantly, trying to challenge and undermine the financial hub and stability status of many of these Gulf cities. So while the Gulf states did not want these US strikes, it's quite possible that the Iranian strategy of widening the pain may mean that in time they actually go on the offensive themselves. Well, that's an interesting…part of the escalatory ladder to watch. A couple of other thoughts or ways in which they've retaliated: at NATO, to a degree. There have been missiles or drones fired at the British RAF base in Cyprus, at a Turkish air base that houses quite a large US contingent. That's important because of the possibility it opens of NATO triggering Article 5 and joining the conflict. I don't think that's widely expected at this point, but it's I think something to be aware of and watch. All this being said, the cadence and intensity of the Iranian response will, we think, in time slow. So on today's White House press conference, the chairman of the joint chiefs was saying that the US thinks it's already seeing that, and there must come a point at which the Iranian missile stockpiles are running down and its ability to retaliate at this level starts to degrade.

Luke Batholomew:

So Lizzy, one critical question for what this conflict means for markets and the economy is, how long it lasts for. And I know this is an extremely difficult question to answer, but what do you think is a reasonable base case for the conflict duration and what factors do you think will determine whether it ends up short or longer than that?

Lizzy Galbraith:

So our current base case is for the conflict to last between two to four weeks. Now, that's partly based on the fact that the US has consistently described its preparations as being for a four-to-five-week conflict, but President Trump has said that they are ahead of schedule. And it's also worth noting that a combination of the oil price rises that we've seen over the past few days, US casualties and the wider regional disruption are likely to incentivize the US to bring operations to an end relatively quickly. It's important to note that it is an election year in the US and oil-price rises transmit very quickly into US gasoline prices for consumers rising. US consumers tend to be very sensitive to that and it's not necessarily something that Republicans are going to want, going into those mid-term elections. So there's lots of incentives for the US to want to bring the conflict to an end relatively quickly and avoid something more drawn out with more long-term disruptions. However, that timeframe assumes that the US is able to reasonably argue it has met its war aims. And there are two principal unknown factors there. The first is whether it's able to end the effective closure of the Strait of Hormuz that Paul was mentioning. President Trump has proposed naval escorts for ships, but any initiative like that is likely to take a few weeks to set up. And in the interim, we're seeing disruption build, more and more oil and gas producers saying that they're not able to meet their current contracts and having to shut down production. So as a reminder, around about 3000 ships are currently affected by that disruption. And the longer the Strait is closed, either wholly or partially, the more that's going to build up. The second factor here is Iran's willingness to come to terms, to accept that the conflict is ending. So nomination of Ayatollah Khamenei's successor is still ongoing. So at the time of this recording, we don't know who that's going to be. But a hardline successor could theoretically refuse to negotiate with the US and seek to drag out the conflict in an attempt to secure more favourable terms, despite, as Paul said, we're likely to see the Iranian military further degraded as time goes on. But there's not necessarily any reason to assume that Iran is going to stop the conflict just because the US does.

Paul Diggle:

Yeah, I think the degree of economic and market pain that the US and the global economy is experiencing is important. We've seen in past episodes of acute geopolitical or broader economic volatility, such as around the April tariff-increase last year, that it was the market that was the check on it all in the end. Now, so question mark about could things get worse to the point in which that then becomes a check at this point? At the moment, I don't think it's a particular factor in the US's consideration of thinking right now beyond, as Lizzy says, talking about maybe escorting some ships out of the Persian Gulf. Another thought is the more military success the US has, does that then push it back into having these very expansive war aims of the sort that Israel also has? So back into the regime change possibility. And I think it's just so important, as Lizzy says, is the US actually in control of the timing? Because there are plenty of scenarios involving complex state collapse, loss of command and control where they just can't, it's not like the US gets to choose when this is over, if there's continued firing of rockets out of Iran.

Luke Bartholomew:

So Paul, on this point of the extent of market pain as a potential check on action, perhaps it's worth spelling out what market reaction has been so far, because we're now on the third trading day since the conflict began. So we have a pretty good sense of how markets are responding to all of this, albeit with the major caveat that this can change very quickly, which seems to be a recurring theme in this podcast. But in general, I mean, the market, unsurprisingly, has traded this as a clear risk-off event, equity prices are lower, especially in Europe and oil and natural gas prices are unsurprisingly, a fair bit higher. So we're talking about large moves, but critically, they are ultimately orderly moves. The market is not dysfunctional, at this point, I think it's important to stress that. And I think there are a few interesting things within those broader asset price moves that I think are worth touching on and bringing out. First, government bonds have sold off in this shock. And it's hard to know up front with a shock like this, how bonds are going to respond, because there are conflicting forces pushing in different directions here. So on the one hand, higher inflation and the possibility that central banks are going to be less accommodative than they otherwise would have been, would tend to push up on yields and so lead to bonds selling off. But on the other hand, a general flight to quality, risk-off kind of environment tends to mean that bond yields fall, that the price increases. And so it's striking that it's that inflation aspect that's winning out for now. And why that's so important is it means that bonds are not hedging against that equity weakness. I think a second interesting thing is that the dollar, the US dollar, is rallying. Now, perhaps that's not so surprising, given that traditionally, the dollar rallies in geopolitical crisis moments, but actually in the last few geopolitical flare ups, think Venezuela and the Greenland crisis, the dollar’s actually tended to depreciate, think around concerns about US institutional credibility and quality, you know, a topic that we've talked about quite a lot on this podcast. So it is interesting that we are back to that old traditional market response this time. And finally, I think perhaps the most surprising move is, at least at the time of recording, gold prices are down. Now, you’d typically think of as gold is almost being the perfect hedge for inflation and geopolitical risk. So the fact that it is not rallying in this, what you assume would be the perfect setup for gold, I think is really quite striking. So Paul, I guess my question for you is, given both the magnitude of the market moves and that correlation structure that I've started to sketch out there, what do you think that the market must be assuming about the nature of the conflict? Or put another way, what looks priced in at this point? And is that realistic?

Paul Diggle:

Yeah, so it's a moving target, but the current oil price in the low 80s per barrel is up sharply, it's up 40% over the year as a whole, because this became increasingly likely, you know, we started to make it our base case over the course of this year, earlier this year as well. But that's still below the 100-dollar average during 2022, the Russian invasion of Ukraine, let alone the 130-dollars-per-barrel peak at that point. Gas prices have moved a lot higher as well at the moment as Qatari LNG has been shut down. But again, the level, about 50 euros per megawatt hour, is still a lot lower than the 100 euros-plus levels in 2022. So I think that price is perhaps a weak, absolute maximum of the Strait being closed, perhaps with some offsetting release of strategic reserves in the meantime, and the hope that spare overland pipeline capacity can be used to redirect supply that way as well. Now, that's not to say that the market doesn't think a bit like we do that the war itself could last a number of weeks, probably weeks, not months, I would say is in the market pricing. But certainly not a war that's over immediately, as the extent of that Iranian retaliation reduces. But I think it's really, it's critical how long the oil supply tap is cut off for. And I would say a week, no more than that, is priced. And meanwhile, if you look at those other markets you pointed out, Luke, equities down, but only by less than 1% in the US, European markets have moved a lot more. Asian markets have moved particularly strongly. But even the cumulative 20% fall in Korean equities this week, it only takes it back to early February levels. Korean equities have risen 50% this year, they're very exposed to the AI trade. There was a big retail mania as well. And I think what's happening there, similar to the 2%-decline in gold prices you were talking about, is it seems to be investors raising cash from previously well performing positions. So I think there's sort of a liquidity squeeze, and you know, what investors call ‘selling your winners’ type liquidation going on. I think the correlation structure you identified is critical and really interesting, important, oil up, equities down, yields up. So as you said, bonds don't diversify equities. That's a key feature of supply-side shocks, which we think are becoming more frequent in a world of heightened geopolitical risk, a world of climate change. And more of these type of shocks will be on the supply side rather than demand side and will show that sort of correlation structure. I think it's really interesting that the dollar is up. So it is a diversifier in this sort of geopolitical shock, when it hasn't been in some of the shocks earlier this year and last year where the dollar sold off because US institutional credibility was often being undermined in the process. And yeah, gold down, I must say, I didn't expect that. And it'll be interesting to see if that remains the dynamic or at some point, gold becomes more of a safe haven bid.

Luke Bartholomew:

And that scenario you sketched out there, Paul, around the length of the conflict, how long the Strait of Hormuz is closed for. Perhaps to some people that might seem quite sanguine. So I mean, what do you think represents a plausible worst-case scenario in terms of a, what would happen to asset prices? And then what would need to happen in terms of the geopolitics, the war for that to occur?

Paul Diggle:

Yeah, so we have a process, as you’d expect at Aberdeen, of running a substantial number of stress scenarios and risk shocks, and understanding exposures in those kind of events. And there is one on the books that we've designed, we call it ‘conflict risk dominates’. The market moves look directionally, as we've talked about, with the exception of the gold selloff. But the magnitude of them is about five times larger than what has occurred, at least as of the market close on Tuesday. So that's only two days in. So you're quite right, Luke, to point out that caveat at the start that much could change. But I think a plausible worst case is oil well above 100 dollars, we had 120 or so in the stress test, equities down a lot more, maybe 5% to 15%, depending on the market. You would think Asia and Europe do worse than the US. Yields and breakevens moving higher. The dollar appreciating perhaps 5% relative to the 1% or so move so far. And maybe have a little bit less faith in the 20%-up-gold move that we'd specified there, but gold playing a safe haven. So that's, I think, what a plausible worst case set of market moves could look like, or at least investors should understand exposures to something that looks like that. Geopolitically, what would be required, I think, is sustained closure of the Strait of Hormuz lasting many weeks, indeed months. Tankers sinking, oil and gas fields, production facilities, hit. There was some concern earlier this week that the actual headquarters of Saudi Aramco were going to be targeted. Civilian deaths in the Gulf, in hotels, in airports. I think all those kind of things would be part of this worst-case scenario. And yeah, big, much bigger market moves, I would suggest, because as you say, Luke, they have been quite orderly. Negative, but orderly, so far.

Luke Bartholomew:

And so that's a plausible worst-case scenario. But I mean, Lizzy, is there an upside scenario where this proves to be much less disruptive than it currently looks like? What kind of things would you need to believe or see to start to see that scenario unfold?

Lizzy Galbraith:

I think there's probably two ways that we could maybe see that come about. And as Paul's mentioned, I don't think it's necessarily anything close to a base case. But the first way, I think, is that the war ends far sooner than expected, and the disruption through the Strait of Hormuz unwinds rapidly. So if we cast our minds back to the 12-day war last year, it actually ended very suddenly. It surprised a lot of people in that it did seem to stop overnight. The US announced it had done a deal with the Iranians, and the talks were going to restart. And that ended the conflict very quickly. It's possible that something similar happens. The US and the Iranians both conclude that continuing the conflict is no longer in their interest, and they switch to talks. And as a result of that, the Iranians stop harassing ships through the straits, and the disruption unwinds quickly, crucially. If the disruption lasts longer, then obviously, we've kind of more back into the base case. But there's optimism that it could be relatively rapid. The other way this could unwind is possibly that the US secures a very favourable political settlement with Iran. That may take longer. But you could either see that play out through possibly a less hostile regime at some point in the future, or through the US securing an explicit role in Iranian oil and gas exports. And as a result of that type of situation, some of the geopolitical risk premia moves out of those prices as it becomes less likely that Iran can act as a disruptive force in global energy markets in the future. So one short-term option, and I guess one more medium-term option that could offer an upside.

Luke Bartholomew:

And then thinking about what all this means for the global economy, I mean, putting a sign on this kind of shock is easy, right? This is a classic negative supply shock, it pushes growth down and inflation higher. But in terms of actually quantifying those shocks, Paul, how should we think about how big this current set of market moves represents to the economy? And how does that compare, say, for example, to the impact of Russia's full-scale invasion of Ukraine back in 2022, for example?

Paul Diggle:

As a rule of thumb, a 10% year-on-year sustained increase in oil prices might add something like 20, 30 basis points to inflation in many major economies. That's a very, very rough-and-ready rule of thumb. It will vary depending on oil intensity, the share of energy in inflation baskets. Generally that is higher in emerging markets, lower in developed markets. You could think of the GDP impact being, sort of, an inverse of that. But again, it varies substantially, it will matter a lot if a country is a net oil energy importer or exporter. I mean, effectively a rise in energy prices is a terms-of-trade shock that transfers wealth from energy consumers, energy producers. In aggregate, the US is a net exporter and producer, but it will still, I think, feel substantial amount of pain at the gas, gasoline pumps themselves. So like, it's a negative shock that will start to play out in the inflation numbers, in the activity numbers, in confidence. As we've been talking about, duration will matter a lot because inflation is a year-on-year concept, so it matters the price level each month. So if you just get a sharp spike and then a reversal, you actually have that quite quickly drop out of the inflation numbers. I think it will, all told, impart a stagflationary feel to the global economy relative to the previous baseline, which let's not forget was actually quite a positive one because we were talking earlier this year about various tailwinds that were coming from AI investment, from stock market wealth effects, fiscal stimulus, perhaps from reducing tariff uncertainty. So it’ll take the edge off some of that. What I don't think this is on the scale of, and indeed even the much larger oil and gas price moves after the Russian invasion of Ukraine did not cause, is a recession in major economies. So I think we have a slightly worse set of numbers in terms of growth and inflation, but I don't think this is cycle-ending.

Luke Bartholomew:

And then how should we expect monetary policymakers to respond to that kind of shock then, Paul? I mean, it had been looking like this was going to be a year of divergence for monetary policy globally, it looks like there was going to be interest rate cuts in the US and the UK, perhaps a hawkish bias to policy in Europe from the European Central Bank, outright interest-rate increases in Japan. Now look, the textbook move is to look through these kind of energy-price shocks. So maybe that basic outlook is unchanged if central bankers can follow that textbook move. But perhaps that isn't possible this time for a variety of different reasons. And instead, the right way of thinking about this is that all these central banks are essentially facing the same shock. So it wouldn't be surprising if their policy response converged if they were facing the same sort of shock. So perhaps after all, this is actually a year of convergence. And perhaps to give that question some bite, does that mean that maybe this talk of rate cuts in the US and the UK were wrong, and we should now be expecting the end of the cutting cycle and maybe even the start of interest rate hikes?

Paul Diggle:

I think that textbook response that central banks tend to look through supply-driven energy price increases is, it was never as simple as that. But it was a very pre-COVID, pre-inflation overshoot thought process as well, I'd suggest. Previously, you might have actually thought of energy price spikes as, in the end, imparting some kind of dovish influence, even into the medium term, because they have these negative demand consequences we've been talking about. But I think the experience of the inflation overshoot, the concern central banks may have that inflation expectations are less well anchored means that I think this is a hawkish impulse. But questions of how long it lasts, how large that inflation rise is, they matter a lot. In the sort of base case that we're expecting and sketching out here, which is by no means benign, could involve further sharp spikes in oil prices. But in the end, they are falling down back again, a month from now, let's say. I think that is tempering the pace of rate cuts by and large, rather than triggering fresh rate hikes. So, current thinking that we have is that our previous expectation for two rate cuts by the Federal Reserve is perhaps going down to one later in this year. And that's regardless of the notion that some of the market might have, that the incoming Fed chair, Kevin Warsh, has sort of pre-committed to Trump that he'll be doing rate cuts. I think a slightly more stagflationary feel to the numbers might mean one cut rather than two. Perhaps the Bank of England is doing less than three. We previously thought they have an upcoming meeting in March where there had been substantial market pricing for a rate cut at that point, and that's now fallen back dramatically. The ECB, we have a forecast that they are unchanged in terms of policy rate this year and then hiking in 2027. I think what's changed there is that the risk has gone from unchanged, but maybe they cut, to unchanged, but maybe they hike. So, I think generally amongst those big DM central banks, at least, that had been in cutting or hold, it's just [a] slightly slower pace of cutting. But it's all caveated on the size of the shock, where oil prices go to, because if we're above $100, then the story changes again.

Luke Bartholomew:

And then finally, Lizzy, stepping back a little bit further still to think about where we are left and how we might describe the Trump doctrine on foreign policy. At times, he's being called an isolationist. At other times, a hemispherist interested in spheres of influence. At other times, he's someone apparently deeply focused, exclusively focused perhaps on superpower competition with China. At other times, he's apparently a Nobel Peace Prize-seeking dealmaker. None of those labels seem particularly well suited to explaining US action in this conflict. So, you know, does that mean US foreign policy is at some level just incoherent, or maybe to put it a slightly more neutral way, or a better way, that there's a lot of improvisation going on? Or is that actually a way of seeing those various strands to Trump's policy as actually being part of a coherent whole?

Lizzy Galbraith:

Yeah, I think it's tricky. And we've often found it quite challenging to predict some of Trump's policy moves in advance. But I think in its simplest terms, the US government would describe its foreign policy strategy as ‘America first’. That is the core of what they're trying to do here. And that might not be a bad framing in that, I think, it allows them to be quite changeable, and in some ways, does undermine the principle of having a written strategy at all, because what is in their interest can change quite significantly depending on the context that we're talking about. But I think you're right to say that, you know, there was a lot of focus when the National Security Strategy document came out about the idea that the US was now focused on hemispheric power at the expense of other areas of foreign policy and defence strategy. And I think that was a bit of a misreading. If you look through the full document, they were certainly interested more in allies sharing the defensive burden, yes, but they weren't explicitly withdrawing from any of these other areas, it was far more of a rebalancing than it was a withdrawal. So maybe one way to look at the consistent factor in Trump's foreign policy in his second term, at least, is to say that the US is willing to respond extremely forcefully where it perceives resistance to its core expectations and its core asks. Both Iran and Venezuela have that in common in that they were resisting US demands prior to military action taking place. And on economic policy as well, President Trump has often escalated with tariffs or tariff-related threats in the face of any resistance to US policy. Even within this, of course, there are exceptions. Russia has been resisting coming to terms with Ukraine in US-brokered ceasefire talks. And that hasn't really resulted in much consequence so far. But perhaps that can be explained by President Trump's belief in the power of personal relationships in foreign policy. And he has a pre-existing relationship with President Putin from his first term that he still sees he has some leverage through. And that was not the case in either of these. And of course, Trump's been fairly hawkish on Iran from his first term as well. We had the maximum pressure policy, then we had the US leaving the Obama-brokered Iran deal. So there is, I think, some precedent here to think that a Trump-led administration is going to be fairly focused on Iran, even as some of the wording around their strategy shifts. But I think, yeah, the overall, Iran does present some challenge to the national security strategy as written. It does seem to counteract the principle of prioritisation that was called to that document. And it also seems to undermine the principle that the US was putting forward in that document that they wouldn't be focused on democracy-building initiatives. President Trump has, of course, put forward the Iranian protests as being one of the reasons why the US has taken action here. So I think, yes, there is still consistency in that approach. But it also maybe cautions us against relying too much on a single written document to predict US policy moves going forward. This is still a US president that makes decisions based on his personal views, often with a very small team around him. And that's not necessarily going to be nuance that's reflected in any policy document written by committee in a more, sort of, standard government format.

Luke Bartholomew:

That's why we're here to bring that nuance. And on that note, that is all we have time for this week. So as ever, please do like and subscribe wherever it is you get your podcast if you have not already done so. And all that remains is for me to thank you all for listening. So thanks very much and speak again soon.

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