Market nerves are jangling again, and this time the trigger is not an interest rate decision in Frankfurt or a GDP miss in Beijing. It is the sound of Israeli jets over southern Lebanon. On Tuesday morning, Israel launched a series of airstrikes into Lebanese territory, responding to what it described as 'provocative actions' by Hezbollah. The militant group had earlier condemned a new regional agreement brokered by the United States, calling it a 'betrayal' of Palestinian interests. The UK Foreign Office has issued a statement urging 'all parties to exercise maximum restraint'.
For those of us who watch the world through the lens of capital flows, this is a familiar pattern. Geopolitical risk tends to concentrate minds in the trading rooms of London and New York. The immediate impact is a flight to safe havens: gold, the dollar, and sovereign bonds. The pound sterling, already under pressure from sticky inflation and a sluggish economy, took a mild hit against the dollar. Gilt yields edged down as investors sought refuge in UK government debt, a classic move during times of uncertainty. But the real story here, as always, is about credibility, credibility of states and of their fiscal and monetary commitments.
Hezbollah’s condemnation of the new deal, which reportedly involves normalisation steps between Israel and a Gulf state, is predictable. The group has long positioned itself as the vanguard of resistance against Israeli expansionism. But from a financial perspective, such deals are often seen as stabilising forces. They reduce the risk premium attached to regional assets and open up trade corridors. The problem is that they also create winners and losers, and Hezbollah, backed by Iran, is on the losing side. The organisation's rhetoric is unlikely to move markets much on its own. But when rhetoric is backed by rockets, or in this case, by Israeli airstrikes, the calculus changes.
Investors should note that the strikes are limited in scope so far. The Israeli Defence Forces said they targeted 'military infrastructure' used by Hezbollah. No casualties have been reported. But the situation is volatile. Any escalation could draw in other actors, including Iran, and disrupt oil supplies from the region. That would be a disaster for global inflation. Central banks are already struggling to tame price pressures. A spike in oil prices would undo much of their work, forcing them to keep interest rates higher for longer. The bond market would not like that.
The UK’s call for restraint is appropriate but unlikely to alter the course of events. The government’s influence in the region is limited, especially post-Brexit. Still, the Foreign Office’s statement is a reminder that the UK has interests in the stability of the Middle East, not least because of the energy links and the presence of British troops in the Gulf. The larger question for investors is whether this is a one-off flare-up or the beginning of a broader conflict. History suggests that Israel and Hezbollah have a tendency to engage in periodic sparring, but both sides have an interest in avoiding a full-scale war. Hezbollah is militarily stronger than it was in 2006, but it is also more integrated into Lebanon’s fragile economy. Israel, meanwhile, is focused on its nuclear threat from Iran.
For now, the market reaction has been measured. The FTSE 100 was down 0.3% in morning trade. Defence stocks, predictably, rallied. BAE Systems and Babcock International saw modest gains. The real test will come if the airstrikes continue or if Hezbollah retaliates. Investors should keep an eye on the oil price. Brent crude was steady at around $85 a barrel on Tuesday, but that could change quickly. Also watch the Israeli shekel, which has been weakening against the dollar in recent days. That is a classic sign of nervousness among foreign investors.
Meanwhile, the UK government’s fiscal plans are unchanged. The Chancellor will no doubt be watching the situation but is unlikely to make any adjustments. The Autumn Statement is still weeks away, and the economy is struggling enough without a Middle Eastern crisis. The real risk is to the inflation outlook. If oil prices spike, the Bank of England will have to raise rates again, pushing up mortgage costs and dampening growth. That is the last thing the housing market needs.
In summary, this is a geopolitical event that bears watching but not panicking about yet. The market has seen this movie before. Israel and Hezbollah are old adversaries. The key variable is Iran. If Tehran decides to get involved, the situation could spiral. But for now, the financial data suggest that investors are treating this as a localised incident. The UK’s call for restraint is a sensible diplomatic move. Let us hope it is heeded.
