Middle East escalation would have severe market implications

Reuters

Amid escalating Iran-Israel tensions, regional business concerns have risen to their highest level since the start of the Israel-Hamas conflict.

On Saturday April 13 Iran launched 300 missiles at Israel, stoking widespread fears of a widening Middle East conflict. Israel has retaliated with a new missile strike but at the time of writing this there have been calls for de-escalation.

To date, markets have not priced in further conflict escalation. There has been minimal reaction from the shekel and Israeli equities since the strike and the oil price remains below $90 per barrel.

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However further escalation of the Middle East tensions could spark significant and serious economic ramifications on a global scale.

Based on early responses to Oxford Economics’ latest Global Risk Survey, two thirds of businesses now see the Middle East as a very significant threat to the global economy over the next two years.

To gauge the potential economic fallout from a Middle East escalation, we quantified an alternative scenario using the Oxford Economics Global Economic Model.

The scenario affects the global economy through different assumptions relating to the degree of energy market disruption and associated financial market stress, plus the accompanying monetary policy response.

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In a scenario of ongoing hostilities between Israel and Iran, the energy market disruption would be substantial and global oil supply would contract by around six percent.

This degree of disruption to global oil supply would be historically significant, with the hit almost as large as that of the aftermath of the 1973 Yom Kippur War.

As a result, oil would spike to $140 per barrel. This price is 60 percent above current levels, but is still a smaller rise than seen after previous oil market disruptions, such as the Gulf War.

This reflects our view that any fallout from any major oil supply disruption today would be less severe than that of previous global crises. 

We attribute this softer impact to the declining energy intensity of production over recent decades, greater diversification of supply beyond the Middle East and the stockpiling of strategic reserves.

Our modelling points to a significant slowdown in global growth in the event of a major escalation of the conflict in the Middle East

Given the smaller oil price impact, the financial market fallout would be less severe than seen previously. Nevertheless, globally, stock markets would still tumble by double digits compared with our baseline. 

Household and business spending would weaken across the globe, as worsening confidence amplifies the direct effect of higher energy prices on spending.

The shock would be amplified by tighter monetary policy as the Federal Reserve, European Central Bank and Bank of England raise policy rates in the face of increasing near-term price pressures.

In summary, our modelling points to a significant slowdown in global growth in the event of a major escalation of the conflict in the Middle East.

However, the pace of expansion would dip only marginally below the pace of population growth – a common definition of global recession.

In all cases, the Gulf would be among the most highly exposed regions to the broadening of the Israel conflict.

While it is likely the region would benefit from the resultant spike in oil prices, its pace of expansion would slow as a result of a drop in oil exports as passage through the Strait of Hormuz – between the Persian Gulf and the Gulf of Oman – is disrupted.

Such a scenario would also disrupt the Gulf’s non-oil trade activities, which rely heavily on functioning logistics and exports facilities.

Moreover travel demand, an important pillar of the non-oil economy, would be disrupted as international tourists avoid travelling to the region and there is a deterioration in the global macro backdrop.

Investor sentiment towards the region will also be dampened, leading to a tightening of investment flows.

In the event of the war escalating in a way that disrupts regional and global oil supply, our scenario analysis suggests GCC growth would be significantly lower this year than the 2.6 percent growth we are currently forecasting.

Scott Livermore is chief economist at Oxford Economics Middle East