The recent volatility in financial markets provides a useful reminder that investors are no better than anyone else at predicting wars and their outcomes.

However, facts can help shed light on some of the possible economic consequences. In the near term, the primary concern is the significant reduction in maritime traffic through the Strait of Hormuz.

Prior to the conflict, over 100 ships passed through the strait each day, mostly laden with oil, liquified natural gas and petrochemicals. It normally accounts for about 20% of global supply, and most of it heads to China, India, Japan and the Far East.

Oil Glut to Oil Squeeze

The closure of the Strait has halted traffic, and only a very small number of ships have been allowed to transit. Most of those ships had been carrying Iranian oil, providing a source of revenue for Iran.

Having failed to negotiate an end to hostilities, the US announced a naval blockade to prevent ships from leaving Iranian ports, presumably with the objective of ending that revenue stream.

In the circumstances, it is no wonder that oil prices increased dramatically, rising quickly from around $60 to over $100 a barrel, reaching levels last seen in the aftermath of the invasion of Ukraine. Although a reopening of the Strait might be negotiated soon, it will take a long time to recover from the supply interruption over the last month or so.

One might have expected the impact on financial markets to have been more extreme. After all, financial markets fell heavily in 2022. It seems that investors expect this time to be different.

Evidence of this view can be found in the oil futures market. It might cost you over $100 for a barrel of oil today, but if you were now buying oil to be delivered in a year’s time, the price would be $80. The most significant driver is that energy markets previously predicted a global oil glut. An increase in supply, combined with slowing economic growth, meant that prices were expected to be driven down. Therefore, the capacity to absorb a prolonged supply interruption is greater now than in 2022.

Although not immune to the price increase, the US is self-sufficient in oil and gas and has plenty to spare. It is the world’s largest energy exporter, so it will be a net beneficiary of the current crisis.

What Next for Interest Rates?

An oil shock creates a dilemma for central bankers. Reduced supply pushes up prices, and that feeds through into the price of pretty much everything. Around half of the oil consumed is used for transportation. Around 15% is used in the manufacture of fertiliser, so a higher oil price means higher food prices. It is also the origin of plastics and so many of the household products we consume, so Inflation rises.

However, higher energy prices act like a tax on consumption, reducing demand and slowing economic growth. The knee-jerk central bank response of higher interest rates to combat price inflation just kicks the economy while it’s down.

It’s an easier square to circle for the US Federal Reserve, which has a dual mandate that requires it to target both inflation and employment. The Bank of England targets only inflation, and the fear is that it will dogmatically increase rates, adding further damage to the UK economy.

The UK is particularly vulnerable, and the OECD has predicted both a reduction in UK economic growth and an increase in government borrowing rates.

What Next for Investors?

Looking forward, we expect investment volatility to persist. We will continue with our highly diversified approach to keep volatility to a minimum. Nevertheless, there are still plenty of opportunities for investors, and we remain confident about the outlook for future investment returns.

Whatever happens, our view is that the combination of structural change to oil supply chains and the loss in confidence of supply from Gulf states will be inflationary. Our client portfolios have been positioned for higher-than-expected inflation over the medium term, and recent events only serve to reinforce our view.