Markets Start To Trade An End To The Middle East Conflict

No War > War

That optimism has been spurred firstly by comments from President Trump, who sounds increasingly keen to bring conflict to an end, not only amid reporting that the US may be prepared to exit the war without having reopened the Strait of Hormuz, but also after recent remarks that the US could cease fighting even without a deal.

Helping things along has been similar comments from the Iranian President, whose powers are somewhat dubious at this point it must be said, who has also noted a preparedness to end the war, provided that guarantees against further attacks are given.

This brings us to the first conclusion that markets are, logically, drawing – no war is a much better scenario for the global economy than a continued conflict. That, in turn, has driven a significant rebound in risk assets, with spoos up 4% from the 6-month lows printed on Monday, as participants increasingly discount a more positive, ‘right tail’ outcome from the current conflict.

Some Hormuz Flows > No Hormuz Flows

One interesting development over the last couple of days, though, is the apparent de-linking of ending the conflict, and re-opening the Strait of Hormuz. Trump put this rather bluntly, telling those countries reliant on energy flows through the Strait to either “just take it”, and to “get your own oil”.

Quite clearly, this leaves the major unanswered question of what the Iranians would do regarding Hormuz if the US were to simply up and leave. The working assumption, for now at least, seems to be that Iran would likely reopen the Strait, albeit while likely retaining tight control over the ships that are able to pass through, potentially also levying a toll on transits too.

Here we can turn to the second conclusion markets have drawn – some oil flowing through an Iranian-controlled Hormuz, is better than no oil flowing through a contested Hormuz. The reaction in commodity prices somewhat speaks for itself here, with both Brent and WTI having dipped back beneath $100bbl, the former below that handle for the first time in a week.

Leaving Difficult Questions For Another Day

Despite all this, relative, optimism, there are still plenty of considerations for market participants, chiefly regarding the longer-run implications of the conflict. The surge in energy prices seen since kinetic action begun means that a rise in headline inflation over the next few months is, essentially, ‘baked in’. Even if conflict were to end immediately, this inflationary impulse is still going to come to pass.

In addition, while re-opening Hormuz is a key priority for markets, to restore a more normal level of commodity flows, one can’t forget about the damage that has been wrought to key infrastructure in the Gulf. Repairing this damage shan’t be an overnight process, and instead could prove protracted, with Qatar having already flagged that LNG production could be impacted for as long as five years.

Added to which, considerably higher energy prices, and continued supply chain disruption, are likely to bring with them substantial growth headwinds, in turn amounting to a notable negative demand shock, which will likely weaken what is already very anaemic economic momentum, most notably in Europe.

This allows us to draw a third conclusion – markets haven’t ignored these risks, but are essentially ‘parking’ these worries, to be dealt with on some other day in the future.

Conclusion

Zooming out, one must ask ‘are we out of the woods yet?’. Given that kinetic action continues in the Middle East, the Strait of Hormuz remains impassable, and much of the market reaction is built more on ‘hope’ than on ‘expectation’, there is still ample reason for a degree of caution. Not least considering that we’ve heard the whole ‘war will be over soon’ umpteen times during the conflict and, clearly, it hasn’t actually ended yet.

Regardless, the rapid way in which participants have seized on perceived ‘good news’ again speaks to the idea that there remains a desire among participants not to get ‘caught short’. While the ‘wall of worry’ is a tall one, and there remain plenty of reasons for caution, few participants are likely to want to be overly bearish, for overly long, given the risk that – as we’ve seen so many times in the past – the outlook could turn on its head once more, in very short order indeed.