Donald Trump may have a coherent plan and well‑defined objectives for the war with Iran; however, if he does, he is keeping it close to his chest. Politicians, journalists and commentators are struggling to decipher what the US President hopes to achieve and what, in his mind, will constitute a successful operation. It appears he wants a quick resolution to the conflict and was perhaps hopeful it could have been resolved in a matter of days, such as with his action in Venezuela earlier this year.
Yet, if he was hoping for a quick victory, it appears likely he will be disappointed, with little change in Iran’s tactics despite the killing of the Supreme Leader and a host of other senior officials. Tehran’s response has been to cause as much disruption across the region as possible, launching attacks on US assets and allies across the Gulf nations while blocking the Strait of Hormuz, preventing oil and gas exports. Iran aims to show the US and its allies that there are large economic costs to pay for the actions taken.
Market Response
So far, this conflict has led to losses across most asset classes. Just prior to the start of hostilities, the FTSE 100 was at 10,900, having surged higher over recent months, and has, at the time of writing, fallen to 10,300. This 5% fall is significant, but given that the FTSE was last at this level in early February, it has not been a huge loss thus far. European and Asian markets have fared slightly worse, but these losses are of a similar scale. US equity markets, meanwhile, have experienced more modest losses as investors return to common ‘flight‑to‑safety’ trades, which has also resulted in a slight strengthening of the US dollar.
Bonds too have experienced losses over the past fortnight, with the yield on the 10‑year gilt rising from 4.3% before the first strikes to 4.7% now, meaning the UK government is having to pay more to borrow. Bonds are often described as the more defensive asset class, but this has not been the case in this instance. Bonds typically perform well when there is a ‘demand shock’, such as in a recession when interest rates must be cut to support consumption within an economy. However, blocked oil and gas exports cause a ‘supply shock’. The risk here is higher energy prices leading to stronger inflation becoming embedded, therefore requiring higher interest rates.
2022 – A Partial Comparison
This is the scenario that happened in 2022 following Russia’s invasion of Ukraine and which led to large losses for both equity and bond markets. Given such a recent comparison, investors and central bankers are nervous of a re‑run and bonds have sold off in anticipation of higher interest rates than would otherwise have been expected.
The comparison with 2022 looms large in the current environment, but there are important differences between the two which make the current situation appear less severe.
Inflation jumped to 11.1% in October 2022, and the Bank of England raised interest rates from 0.5% at the time of Russia’s invasion to a peak of 5.25% in August 2023. Should such increases be experienced again, then large losses across markets could be expected. However, this appears unlikely at this stage. UK inflation, as measured by CPI, is currently 3%, and prior to the Iran war starting this had been expected to fall to 2% by the end of 2026. Earlier this week the Office for Budget Responsibility (OBR) stated that should the current oil price be sustained then inflation could be expected to increase back up to 3% by the end of the year. This prediction was heavily caveated with warnings that further oil price gains would clearly lead to even higher inflation, but it is useful as a reminder that despite the similarities with 2022, a repeat of that surge in inflation and interest rates is not the base‑case expectation.
The key explanation of why the present situation differs to 2022 is that back then was not just an energy price shock. There were two further factors in that inflationary shock. As the global economy bounced back from the covid lockdowns, a combination of huge stimulus and a desire to spend met constrained supply chains. Also, the six‑day blockage of the Suez Canal by the Ever Given container ship in March 2021 caused massive backlogs in moving goods from Asia to Europe, laying the foundations for the supply‑shock inflation that would emerge over the following years.
It therefore seems unlikely that the war in Iran will have the same impact on inflation and global markets as was experienced in 2022, but it has already had a significant impact.
Managing the Way Forward
It appears that Trump wants this war to end quickly, and an obvious reason for this is the US mid‑term elections in November. Should the war be rumbling on and gas prices be high for US consumers, the Republican Party could be in trouble, given Trump’s previous promises of taking the US out of ‘forever wars’ and his criticism of Joe Biden for the previous inflation spike.
While Trump started this war, it will not be solely down to him when it ends. The duration of this blockage to energy exports is the main financial question of this conflict and will be key in determining the direction of investment markets.
Volatility levels have been high since the outbreak of this war, and there have been large swings in markets from one day to the next. In managing the Future Money portfolios during this period, we are remaining patient. Our investment philosophy is focused on long‑term investment trends. We expect that hostilities will eventually fade and shipping will resume through the Strait of Hormuz and that in this situation, energy prices will subside. It is our belief that this will not lead to a major global recession and therefore we retain faith in equities overall. Within this, valuations remain more attractive in non‑US markets and so we retain our focus in these areas. Within bonds, we continue to favour higher quality bonds, which provide a good yield, but which would also provide protection should signs of a recession emerge over the coming years. As such, while the current volatility is creating short‑term valuation opportunities, which we are taking advantage of, at a strategy level our investment themes are being maintained.