The world’s most important financial artery just became a little more inflamed. US forces have struck Iran in retaliation for an attack on a cargo ship, and Downing Street has wasted no time in throwing its weight behind the American response. For markets, this is not a moment for sentiment. It is a moment for calculation.
Let us consider the immediate arithmetic. The Strait of Hormuz handles about 20% of the world’s oil. A strike on Iran is not a pinprick. It is a sledgehammer aimed at the global energy supply chain. Oil prices will spike. I do not need to tell you that. But what you might not have factored is the effect on gilt yields. When geopolitical tension rises, investors flee to safety. But safety in the current climate is a relative term. US Treasuries, German Bunds, and yes, UK gilts, will see a surge in demand. That will drive down yields initially. But the Bank of England will be watching inflation expectations like a hawk. If oil prices stay elevated, the inflation premium will creep back in. The Bank cannot afford to look dovish now. It will have to tighten further, or at least sound as if it will.
Then there is the matter of capital flight. Iran’s economy is already under severe pressure from sanctions. But this strike will accelerate the flow of capital out of the region entirely. The UAE, Saudi Arabia, even Qatar: they will all see a risk premium attached to their assets. Money will head for London and New York. That is good for the pound in the short term, but it also increases the cost of hedging. And the longer the conflict festers, the more that hedging eats into corporate profits.
Let me also address the fiscal angle. Downing Street’s backing is politically necessary, but it is also a reminder that the UK government is now committed to a conflict that could demand resources. Defence spending will rise. That means either higher taxes or more borrowing. The Chancellor will not want to admit it, but the fiscal rulebook is about to be rewritten. Inflation will be the excuse, of course. But the real story is that the market will test the UK’s resolve to maintain fiscal discipline. Gilt holders, take note.
And what of the central banks? The Federal Reserve will now have to factor in supply-side shocks from oil. That will make their rate decisions even more delicate. They want to pause, but Iran may force their hand. The European Central Bank will be equally cautious. The Bank of Japan? They have their own problems, but a weaker yen is now more likely as capital flows to the dollar.
I realise this sounds cynical. But that is my job. The news that Downing Street backs the American resolve is not a story of solidarity. It is a story of economic consequences. Markets will price in the higher probability of a prolonged conflict. Portfolios will be rebalanced. And the ordinary investor will wonder why their pension fund just lost 2%.
So here is the bottom line: sell anything with exposure to oil-dependent industries. Buy defensives, but be selective. Watch the 10-year yield. And understand that every bomb dropped is a variable that no spreadsheet can fully capture.
