The escalating cycle of strikes between the United States and Iran is a reminder that geopolitical risk is back with a vengeance. For investors who had grown complacent in a world of low volatility, the sight of American and Iranian forces exchanging blows is a cold shower. The immediate trigger: a US drone strike on a senior Iranian commander, followed by Iranian retaliation on Iraqi bases housing American troops. The rhetoric from both sides is bellicose, and the prospect of a full-blown conflict is no longer a theoretical exercise.
Britain, ever the voice of caution, has urged restraint. But let’s be clear: restraint is a luxury that markets cannot afford when the world’s most important oil transit chokepoint is at risk. The Strait of Hormuz, through which 20% of global oil passes, is a hair trigger. Any disruption there would send crude prices soaring, and with them, inflation expectations. The Bank of England would be forced to confront a stagflationary shock: rising prices and slower growth, a nightmare for policymakers who have been wrestling with Brexit-induced uncertainty.
The gilt market is already pricing in the risk. The yield on the 10-year gilt has been volatile, reflecting the flight to safety that typically accompanies such crises. But the irony is that the UK is not immune. A prolonged standoff would push up oil import costs, exacerbate the current account deficit, and put pressure on sterling. The triple-A rating is not as secure as it was a decade ago.
The market’s obsession with fiscal responsibility is also on display. With government borrowing already elevated, any additional spending on defence or emergency measures would be met with suspicion. Investors are watching the Chancellor’s every move, and any hint of fiscal incontinence would be punished with higher gilt yields.
Capital flight is another concern. The uncertainty of a Middle East conflagration could see capital flowing out of riskier assets and into the dollar, further weakening the pound. Emerging markets, already fragile, would suffer especially hard. But London, as a financial centre, might benefit from a flight to quality if the situation is contained. However, that is a big if.
Central banks are in a bind. The Federal Reserve and the Bank of England have been navigating a delicate path between supporting growth and preventing inflation. A geopolitical shock could force their hands: either ease to cushion the blow, risking a rebound in inflation, or stay the course and accept slower growth. The market’s reaction to the last Fed meeting, where it signalled a pause in rate cuts, suggests that fear of inflation still dominates.
The bottom line: the US-Iran standoff is a reminder that the global economy is not as resilient as markets had assumed. The risks of a miscalculation are high, and the cost of a mistake would be borne by taxpayers and investors alike. Britain’s call for restraint is sensible, but the market’s verdict will be delivered in real time: watch oil prices, watch gilt yields, and watch your portfolio. The game is dangerous, and there are no clean exits.
The time for complacency is over. Investors should brace for a period of heightened volatility, where the only certainty is that the cost of risk is about to rise.
