The illusion of stability in the Middle East has been shattered. The United States and Iran have resumed direct hostilities, exchanging airstrikes and trading accusations over who violated the fragile ceasefire first. For those of us in London who watched the diplomatic charade with a raised eyebrow, this escalation is less a surprise and more a confirmation that markets had correctly priced in a risk premium that the politicians denied existed.
Let us be clear: the ‘ceasefire’ was never more than a temporary reprieve, a pause in a cycle of violence that has defined US-Iran relations for decades. The first reports filtered through from the Gulf: explosions near Iranian military facilities, followed by Iranian retaliatory strikes against US positions in Iraq. Both sides have predictably blamed the other. Tehran’s state media claims the US struck first under the flimsy pretext of “defensive operations.” Washington’s briefings insist Iran was massing proxies for an offensive. It is a cacophony of blame that, frankly, is background noise to the only question that matters: how high will the oil price go?
By my estimation, the market has not yet fully repriced this risk. Brent crude spiked $3 on the initial reports, settling around $85 a barrel as I write, but the real test will come if the Strait of Hormuz is threatened. Any disruption to that chokepoint and we could see a 20% surge overnight. That would be a direct tax on every British motorist and business, feeding inflation just as the Bank of England thinks it has got the dragon under control.
The Treasury and Foreign Office will be burning the midnight oil. Whitehall’s official response has been the usual carefully worded concern: “The UK urges restraint and calls on both parties to return to the negotiating table.” But behind the scenes, the real work is a stress test of the Treasury’s fiscal models. Every percentage point rise in the oil price adds billions to the UK’s import bill, and that capital has to come from somewhere. It will show up in the gilt market as foreign buyers demand a higher premium for holding our debt. If the crisis deepens, expect the 10-year yield to push through 4.5%.
Meanwhile, the capital flight has already begun. The Japanese yen and Swiss franc are the usual havens, but the real money is moving into physical gold and, ironically, US Treasuries. The hypocrisy of buying the debt of the country you are accusing of warmongering is not lost on me, but markets are amoral. In a crisis, liquidity is king, and the US government bond market is still the deepest puddle.
For the ordinary British investor, the advice has not changed: diversify away from any single-asset bet on Middle East peace. Defence stocks have already rallied, and I expect that trend to continue. BAE Systems and other contractors will see a bump in their order books as both sides resupply. But do not chase the momentum too hard. The real play is on volatility indices and energy companies with low production costs that can weather the storm.
The key takeaway for the fiscally minded is this: government spending on foreign interventions is never costed properly. The current crisis will pressure the Chancellor of the Exchequer to find more funds for defence, and that means either cuts elsewhere or higher borrowing. Neither is palatable. The era of low inflation and cheap money is well behind us. Now we face the hangover of decades of fiscal incontinence, with a geopolitical crisis as the catalyst.
I will be watching the next round of economic data with a particularly cynical eye. If this crisis persists, the Bank of England will have to choose between fighting inflation and supporting growth. In my experience, they always choose the former, and the price will be paid by the working household through higher mortgage rates and lower real wages.
So, the strikes are a tragedy in human terms, but for those of us in the financial machine, they are a data point. A very expensive one. The ceasefire was a fiction we could ill afford to believe. Now the market wakens to reality.
