In a move that sent shockwaves through the markets and raised the spectre of regional instability, Israel launched a series of airstrikes into southern Lebanon early this morning. The escalation comes at a particularly delicate juncture, as the government finalises a controversial new trade agreement with the Gulf states. The Foreign Office has issued a statement urging all parties to exercise restraint, but the damage to investor sentiment may already be done.
For those of us who have watched the Middle East for decades, this is a familiar pattern. A flare-up, a call for calm, and then the slow creep of uncertainty back into the financial system. But this time, the context is different. The pound is already under pressure from sticky inflation and anaemic growth. Gilt yields have been on a rollercoaster as the Bank of England tries to keep a lid on expectations. The last thing the Exchequer needs is a security crisis that sends capital scrambling for the exits.
The airstrikes themselves appear to be targeted, but the underlying tensions are anything but. Hezbollah has been flexing its muscles, and the new Israeli government is more hawkish than its predecessor. The Foreign Office's carefully worded statement – calling for de-escalation while reaffirming Israel's right to self-defence – is typical diplomatic fudge. But the markets are less forgiving. The FTSE 100 opened lower, and the pound lost ground against the dollar and euro. Safe-haven assets like gold and the Swiss franc saw a modest uptick.
What concerns me more is the timing. The UK is on the verge of signing a landmark trade deal with the Gulf Cooperation Council. This deal has been years in the making, and it is crucial for post-Brexit Britain's pivot to emerging markets. But any whiff of regional instability could spook the Gulf sovereign wealth funds. They are the ones who have been buying up UK assets at a discount. They hold significant stakes in everything from energy to infrastructure. If they start to pull back, the fallout would be felt across the board.
The Treasury is undoubtedly watching this closely. The Chancellor has staked his reputation on fiscal responsibility, but a dual shock from inflation and geopolitical risk could force his hand. The bond market is already pricing in a higher risk premium. If this escalates, we could see gilt yields spike further, raising the cost of borrowing for the government. That would put pressure on public finances at a time when the health service and defence are already struggling.
There is also the question of capital flight. The UK has always been a safe haven for global capital, but that status is under threat. The uncertainty around Brexit, the rise of the SNP, and now this Middle East turmoil could push wealthy investors to look elsewhere. Singapore, Switzerland, even Dubai are all vying for the same pool of capital. If the UK is seen as too risky, that capital will move.
The Foreign Office is right to urge de-escalation, but words are cheap. The only thing the markets care about is action. If Israel and Hezbollah can be persuaded to step back, then this will be a blip. But if the strikes widen, or if Hezbollah retaliates, then we could be looking at a full-blown crisis. The stock market may be resilient, but the bond market is the true barometer of fiscal health. And it is flashing red.
In summary, this is a reminder that geopolitical risk is never fully priced in. The trade deal with the Gulf states was supposed to be a triumph for British diplomacy. Now it hangs in the balance. The Bank of England will have to factor this into its next rate decision. And the Chancellor will have to hope that his fiscal headroom is enough to absorb the shock. I have my doubts.
For now, all eyes are on Tel Aviv and Beirut. The markets will hold their breath. But they don't hold it for long. Every moment of uncertainty is a moment of opportunity for the bears. And the bulls are getting tired.
