The US bombing of Iran and involvement in the Midde East conflict will take centre stage this week, in which the calendar is otherwise filled with inflation data from various countries and testimony from Fed Chair Powell. Risk‐off sentiment is likely with sharp moves only contained if Iran retaliation is also contained. There is much jawboning at present and the situation is extremely volatile and fluid. The oversold and undervalued US dollar should benefit from safe haven flows as it did last week via higher oil prices. That is because the US has turned from a net energy importer to a net exporter. But the greenback has lost some of its haven status in recent months due to well-known domestic factors.
Investors knee-jerk response to the weekend’s bombing will be to flock to other traditional safe haven currencies like the yen and swissie, which should appreciate along with gold and petro-currencies such as CAD and NOK. As we wrote last week, much will still depend on any restraint in retribution by Iran, and crucially whether there is actual disruption in shipping through the Strait of Hormuz. This could impact oil flows from the Persian Gulf, through which almost a third of global seaborne oil trade moves.
Regarding stocks markets, quite often an event such as military action leads to a sharp sell-off before equity gains because in simple terms, wars cost money and the increased spending boosts the economy. In addition, western politicians are more likely to pursue policies that increase spending in the immediate aftermath of a military conflict as a way to keep voters happy. Historically since 1939, the benchmark S&P 500 US stock market index tends to fall around 6% in the three weeks after a geopolitical shock, only to recover fully over the subsequent three weeks. Furthermore, history suggests that oil prices need to double before they can inflict a recession in the west.
Important for broader equity markets will be long-term US monetary policy and market expectations around the global economic outlook. The most recent FOMC meeting saw Fed Chair Powell downplay the risk of persistent inflation pressures stemming from the conflict, which is in line with the central bank’s tendency to look through short-term volatility in financial conditions. We note that the current Fed model has a $10 jump in the oil price leading to 0.4% drag on US GDP and 0.35% rise in inflation. That is a stagflationary scenario and central banker’s biggest worry, which was also reflected in the Fed’s most recent summary of economic projections.