The familiar drumbeat of conflict in the Middle East has once again spiked market volatility, as Israel confirmed a 'targeted strike' on Beirut. For those of us watching the bond markets, the immediate flight to safety was predictable. Gilt yields saw a sharp but temporary dip as investors sought haven in UK government debt, a reflex reaction to geopolitical uncertainty. But the question that should keep Chancellors awake at night is: how much will this cost the taxpayer?
The UK response, calling for 'immediate de-escalation', is the diplomatic equivalent of throwing a bucket of water on an oil fire. It sounds sensible, but it rarely works. Prime Minister Starmer’s statement, however, was carefully calibrated to avoid triggering further capital flight from London's financial hub. The City remembers all too well how regional instability can rattle investor confidence. The last time Beirut was in the headlines, we saw a spike in insurance premiums across the Levant and a dip in foreign direct investment into the region. This time, the stakes are higher.
From a fiscal perspective, the timing could not be worse. The UK is already grappling with stubborn inflation, a hangover from energy price shocks. A prolonged conflict threatens to push oil prices higher, which would feed directly into CPI. The Bank of England will be watching this with hawkish eyes. If oil stays above $90 a barrel, don't expect rate cuts anytime soon. That means mortgage holders will continue to feel the squeeze, and the government’s borrowing costs will remain elevated.
Let's talk about defence spending. The strike comes at a time when NATO allies are under pressure to meet the 2% GDP threshold. If this escalates, expect calls for a larger defence budget, which means either higher taxes or more borrowing. The Treasury will be pencilling in worst-case scenarios. Capital flight is the silent killer here. If investors perceive the UK as being dragged into another Middle Eastern quagmire, they will vote with their feet. We've seen it before: a sell-off in sterling, a widening of the risk premium on UK gilts.
The market's initial reaction was muted, but don't be fooled. The VIX, Wall Street's fear gauge, ticked up. The real test will come if Hezbollah responds. That would put Israel's northern border in play and could drag in Iran. For the UK, the immediate concern is the safety of British nationals in Lebanon and the potential for another evacuation operation, which is a costly and logistically complex endeavour.
I remain sceptical about the efficacy of diplomatic pleas. The UK's influence in the region has waned, and both sides have their own calculus. The market is pricing in a low probability of a full-scale war, but tail risks are being reassessed. For investors, the playbook is simple: trim exposure to aviation, energy, and defence stocks may pop. For the UK government, it's a reminder that geopolitical risk has a price, and it's one that will eventually appear in the budget deficit.
The bottom line: this is a manageable shock for now, but the trajectory depends on Iranian involvement. The UK should be preparing for higher oil prices, a stronger dollar, and a bumpy ride for gilt yields. Fiscal responsibility demands that we do not borrow our way out of this. Let's hope the Foreign Office has a better plan than 'de-escalation'.
