Global Financial Markets Rocked by Israel-Iran Conflict Escalation

UK Prime Minister Keir Starmer said there were no “hiccups or obstacles” remaining in the way of finalizing a trade deal with the US and indicated that an agreement would likely come soon.

“I’m hoping that we will complete it pretty soon,” Starmer said in an interview with Bloomberg News on Friday, referring to the deal. “There’s nothing unexpected in the implementation, and so we haven’t got any hiccups or obstacles.”

Starmer’s government is trying to hammer out the final details of its trade deal with the US, whose broad outlines were first agreed to in May in a move to head off President Donald Trump’s more punitive tariffs. While the UK was the first country to have reached such a deal with the Trump administration, but left the finer points to future negotiations.

Under the initial terms announced last month, the US said it intended to cut its tariff on cars imported from the UK from 27.5% to 10% for the first 100,000 vehicles each year and to slash levies on UK steel from the current 25% to zero. In return, the UK vowed to increase the quota of beef and ethanol that the US can export to the country tariff-free.

Pushing the deal over the line would be seen as a win for Starmer, who was elected last July on a promise to boost economic growth in the UK. That has so far proved elusive and his popularity has slumped during his 11 months in office. But agreeing a deal before any other country would help to give UK manufacturers a competitive edge.

Car manufacturers would especially welcome the reduction of US tariffs after warning that Trump’s levy could wreak havoc on the sector and risk thousands of jobs. Starmer said the initial terms of the trade deal laid out in May were “a huge relief to car manufacturing, those working in the sector,” adding that there were “jobs protected, jobs created by this deal.”

Securing agreement on the entire deal would also bring relief to the UK’s beleaguered steel sector. The UK is currently the only country to avoid the 50% tariff on steel that Trump announced last month, but that higher rate could still be imposed if a deal is not reached. British companies have already reported US orders drying up under the 25% rate.

A deal could depend on Downing Street easing US concerns over the Chinese ownership of British Steel. Jingye Group still holds the plant even though the UK government took over operational control earlier this year.

Source: Yahoo Finance

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Source: Finance-commerce

What’s happened

Israel has launched coordinated strikes on Iran’s primary nuclear and ballistic missile facilities, as well as targeting senior IRGC commanders and nuclear scientists. In response, Iran has retaliated with approximately 100 drones aimed at Israeli territory and marking a major escalation in regional hostilities. Israel has declared a state of emergency, framing the strikes as pre-emptive and warning of further operations.

Whilst the US has not been directly involved, Iran has accused Washington of complicity and may target American assets in the region. Previously, the US had restrained Israeli action amid ongoing nuclear negotiations, but those talks now appear stalled. Equally, maritime security risks have surged in the Strait of Hormuz, the Persian Gulf, and surrounding waters, critical chokepoints for global oil and LNG trade. Although energy infrastructure has not yet been targeted, the threat of future strikes could disrupt supply chains and further drive up prices. Any restrictions to maritime trade are equally likely to have longer-term implications should Tehran determine that a blockade is an effective method of retaliation which avoids direct targeting of regional US assets.

Meanwhile, the International Atomic Energy Agency’s (IAEA) recent censure of Iran has further isolated Tehran diplomatically. Iran now faces a pivotal choice: pursue a nuclear breakout, with a weapon potentially achievable within months, or return to negotiations under the weight of severe economic sanctions. A breakout would significantly alter the regional balance and almost certainly trigger US military intervention.

With further Israeli strikes likely, Iran’s drone attack is unlikely to be Tehran’s final response. Tehran must weigh the need of reasserting deterrence, taking into account a depleted proxy network, against the risk of provoking a broader war and direct US involvement. While past behaviour suggests Iran may ultimately de-escalate to preserve regime stability, the situation remains highly volatile.

The impact on energy markets and potential escalation scenarios

An elevated level of geopolitical uncertainty requires energy markets to price in a large risk premium given the potential for supply disruptions. The strikes on Iran initially saw oil prices rally 13%, although markets have given back some of these gains. In the absence of any actual supply disruptions to Iranian oil flows, we suspect the rally will continue to fizzle out. However, the market will need to price in a larger risk premium than it was prior to the attacks, at least in the short term, leaving Brent to trade in a $65-70 range.

Any escalation that leads to a disruption in Iranian oil flows will be more supportive for prices. Iran produces roughly 3.3m b/d of crude oil and exports in the region of 1.7m b/d. The loss of this export supply would wipe out the surplus that was expected in the fourth quarter of this year and push prices towards $80/bbl. However, we believe prices would finally settle in a US$75-80/bbl range. OPEC sits on 5m b/d of spare production capacity and so any supply disruptions could prompt OPEC to bring this supply back onto the market quicker than expected.

A more severe scenario is if escalation leads to a disruption in shipping through the Strait of Hormuz. This could impact oil flows from the Persian Gulf. Almost a third of global seaborne oil trade moves through this chokepoint. A significant disruption to these flows would be enough to push prices to $120/bbl. OPEC’s spare capacity would not help the market in this case, given that most of it sits in the Persian Gulf. Under this scenario, we would need to see governments tap into their strategic petroleum reserves, although this would only be a temporary fix. Therefore, significantly higher prices are needed to ensure demand destruction.

This escalation also has ramifications for the European gas market. However, to see gas prices moving significantly higher, we would need to see the worst-case scenario play out - disruptions in the Strait of Hormuz. Qatar is the third-largest exporter of LNG, making up around 20% of global trade. And all this supply must move through the Strait. The global LNG market is balanced now, but any disruptions would push it into deficit and increase competition between Asian and European buyers.

The economic impact and what it means for central banks

The spike in oil prices threatens to disrupt the current narrative surrounding US inflation, which has proven more benign than expected in the face of US tariffs. So far, goods inflation has stayed remarkably calm, while price pressures within services, which represent three-quarters of the core CPI basket, have begun to ease.

We don’t think that will last. Inventory buffers may have allowed firms to put off decisions about raising prices, but that won’t be the case for much longer. We expect to see bigger spikes in the month-on-month inflation figures through the summer. The Fed’s recent Beige Book cited widespread reports of more aggressive price rises coming within three months. Higher oil prices only add to that.

Ten years ago, central banks, including the Federal Reserve, would have viewed an oil price spike as a dovish factor for interest rates. Weaker growth typically outweighed concerns about a short-lived spike in inflation. But that thinking has changed considerably since the Covid pandemic. In Europe, the 2022 natural gas and oil price spike fed a long-lasting pick-up in service-sector inflation. Officials at both the Federal Reserve and Bank of England have warned about a similar feedback loop emerging today. The Bank for International Settlements has warned central banks that it will be harder to simply look through supply shocks.

Those fears may be overblown. Through both the pandemic and 2022 energy price shock, the broader economic environment was ripe for inflation to take off. In both cases, governments offered substantial fiscal support to offset the impact, a task made much harder today by higher interest rates and jittery financial markets. And the jobs market was considerably stronger too. In 2022, there were two job vacancies for every US worker. Now there is only one, which is below pre-pandemic levels. The scope for a resurgence in wage growth is more limited.

Higher oil prices clearly reduce the chances of the Federal Reserve cutting rates in the third quarter. We already felt those chances had fallen over recent weeks. But by the latter stages of the year, we think the impact of tariffs on inflation will begin to wane and service-sector disinflation will have gathered pace. At the same time, the economic hit from the US trade war will have become more apparent in areas like unemployment. We expect the first Fed cut in the fourth quarter, potentially starting with a 50 basis-point cut in December. A rapid string of cuts could take rates down to 3.25% by mid-2026.

These developments also make life harder for the European Central Bank. Eurozone inflation has been muted over recent months thanks to lower energy prices. That risks changing now, and higher costs are yet another concern for the manufacturing sector.

It’s a further hit to confidence, which is already weak thanks to broader geopolitical and economic uncertainty. Consumers are saving more, and firms are delaying investment. A further escalation in Middle East tensions would add to that negative sentiment and weigh on growth.

If that happens over a prolonged period, the eurozone outlook becomes more stagflationary. An ECB scenario shows that a 20% spike in energy prices could cut growth by 0.1pp in both 2026 and 2027. Inflation would be 0.6 and 0.4pp higher, respectively, relative to its base case. While we’re not yet in this more extreme scenario, it makes it tricky for the ECB to respond. Higher energy price volatility means the ECB will look even more closely at underlying inflation. We expect one more ECB rate cut in September, though President Christine Lagarde will be happy that she can use the recently announced pause to see how things play out before deciding whether to cut rates below neutral.

Impact on FX

The dollar has rebounded on the Israel-Iran developments overnight, but is still far from recovering losses from earlier this week. We think the impact on equities (US stock futures down) is holding back dollar gains, as the greenback now has changed its sensitivity to risk sentiment.

Should tensions spiral into a broader conflict and oil prices rise further, there should be more upside room for the dollar, which is already oversold and sharply undervalued in the near term. But the dollar's relatively contained rally this morning is another testament to the fact that it has lost some of its safe-haven status, and a lingering structural bearish bias remains. That is entirely due to US domestic factors, so we doubt an external event (like geopolitical tensions) will fix the damage done to the dollar. Expect active buying on the dips in EUR/USD on any indication of a de-escalation. The yen, in our view, remains the most attractive hedge.

Impact on market rates

Markets had already responded on Thursday to escalating tensions around Iran, with German government bonds reaffirming their safe-haven status as they began to outperform swaps. Following the actual news of military strikes on Iran, the market's knee-jerk flight-to-safety reaction soon faded and gave way to concerns surrounding the monetary policy implications - the curve bear flattening points to stagflationary worries, as does the rise in shorter-dated inflation swaps.

In the broader context, the rates market’s reaction will likely remain muted, however. Tariff policies, fiscal concerns in the US and spending prospects in the EU have already made for an uncertain environment – the escalation in Iran only adds to the noise. Markets are still eyeing one more cut from the European Central Bank to 1.75%, though have started to trim chances of the ECB moving beyond that. In longer rates, the 10y swap rate rose somewhat above 2.5% again, but remains well within recent ranges.

Impact on credit markets

Recently, credit markets have absorbed and ignored all external factors of concern. Abundant liquidity has taken down significant supply whilst spreads have tightened considerably at the same time, often to the tightest levels this year. The effect on credit spreads should therefore be muted, for the time being, as these strong technicals continue to drive spreads whilst external factors are being ignored. The initial spread reaction is to widen a little, but if these geopolitical tensions do not escalate, the credit market can quickly revert to its tightening trend.

However, longer-term uncertainty for the corporate balance sheet dominates, and higher commodity prices and inflation impact margins - another credit negative. Cyclical and manufacturing-related sectors have outperformed of late, but we could well see a retracement of that move as the case for a more defensive credit stance continues to build.

Source: ING

Geopolitics is once again making its presence felt in financial markets. This morning (in the UK at least) we woke up to the news that Israel has launched airstrikes designed to damage Iran’s nuclear capacity, and Iran has retaliated with drone strikes. You can read our rolling blog here.

My beat is investment, and that’s the aspect of this event that we’ll be talking about here. It should go without saying that this does not mean I’m underplaying any other aspect of this conflict.

Big geopolitical events — even ones that don’t directly affect you — can lead you to feel that you must act in some way. The headlines are noisy, the markets are turbulent, and it’s easy to be persuaded by the hubbub that you should in some way be joining in.

It’s my job today to remind you that you have no obligation to do anything whatsoever, and for most of you, it’s probably best that you don’t.

You cannot predict the future. This situation either escalates from here, or it doesn’t. You are probably not in a position to know either way. And even if you did know, positioning your portfolio “correctly” would still be something of a guessing game.

In terms of probabilities, the most obvious one is that you can probably assume that the oil price will likely remain higher than it otherwise would have been. Tom Holland over at Gavekal reckons we can probably kiss goodbye to the idea of oil going back to the sub-$60 a barrel lows we saw earlier this year.

That’s likely to be good news for oil producers. As for the wider economy, if the oil price stays high, then that will have a knock-on effect on inflation — pushing it higher. You’d probably also get a knock-on effect on economic growth, in that it will hurt it.

Also, you can point to other industrial sectors that might be helped or harmed by this news — although the arguments are likely much more nuanced than you’d initially assume.

My point is you could sit and rack your brains and throw these scenarios around in your head all day. Some people do that for a living, and some people do it for fun. But if neither of those scenarios describes you, then the truth is, it’s a waste of your time.

Instead, as I always say, don’t panic, and stick to your plan.

But what do I mean by that?

The main goal of most people’s financial plan is to ensure that they have enough money to retire at the age they hope to, and with the standard of living they desire.

There will be other goals in there, depending on your life stage: home ownership, potentially educating your kids, and for the very well off, contemplating your financial legacy. But the big one is: When can I stop working, and how much do I need to do so?

So you work and you steadily put money away with the aim of reaching that goal. And once you retire, you nurture that money with the aim of making sure it lasts.

That’s quite a task when you think about it. Sure, life might get a bit cheaper once you’ve retired, assuming you don’t have a mortgage anymore, for example. And there’s the state pension.

But if you want to be able to pack in your job and replace enough of that income to maintain your standard of living, then you’re going to need the money you save towards that goal during your working life to not just maintain its value (ie beat inflation) but also to grow.

This is why we don’t just stick our long-term savings in a piggy bank. With the caveat that past performance is no guarantee of future performance, history shows that of all financial assets, over the long run, equities deliver the best returns.

Why do equities deliver the best returns? Basically, because they involve taking more risk than holding cash, or lending money to reliable borrowers (investing in highly-rated bonds). If they didn’t offer better returns, it wouldn’t be worth taking the risk.

By “risk” though, the financial world basically means price volatility. In other words, if you own a portfolio full of equities, and you watch the price every day, you’ll have a much more stressful time of it than if all the money was in bonds, or in cash.

However, assuming that you diversify across lots of equities and are thus protected against more existential forms of risk — like the risk of an individual stock going bankrupt and taking all your money with it — then the long-term returns should beat those of other financial assets.

What other assets might you own as well? Bonds (for diversification and an element of stability), gold (as portfolio insurance), and cash (always useful for keeping your options open). Property is really just another form of equity, but you might want to think about it separately.

Within all that, the question of how you divvy up your portfolio between assets boils down to how active an investor you want to be (or feel you can be) and how lengthy your time horizon is. Broadly speaking, the further you are from retirement, the more risk you can afford to take.

I talk more about the point of asset allocation here and about the “primary colours” of investment here. My own broad philosophy is “try to own more of what’s cheap, and less of what’s expensive.” However, there are differing opinions on all this stuff — that’s what makes a market.

Fundamentally though, it’s the “having a plan” that’s important. It means that when unexpected and noisy events like this occur, you are in a better position to a) not panic and b) consider using any unusual price moves to buy attractive assets at lower prices.

In the absence of crystal balls, it’s your best strategy for coping with an uncertain world.

Source: Bloomberg Europe

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