Are Markets Moving On From Middle East War?

There was some tension in financial markets on Tuesday, as the hours counted down to US President Donald Trump’s deadline for a ceasefire with Iran. But no talks happened, and the deadline was extended. Markets were relieved, but the move was smaller and more diffuse than in prior instances of a deadline.

An increasing number of analysts say the market is moving on from the war. The worst-case scenario seems to be in the rearview mirror, which means there is less risk premium. While headlines around the Middle East War can still bop markets in the short term, investors are starting to price in the new normal. That has important implications for Forex markets.

Higher Energy Costs Have Winners and Losers

The consensus seems to be that the Middle East War will be over soon, one way or another. On the other hand, it also seems that large oil flows through the Strait of Hormuz are unlikely in the near term. This has left analyst pricing in a “new normal” in which Brent and WTI trade around $20 per barrel higher than before the war. That implies an increase of around 30% in petroleum-based energy costs.

Higher costs and a concurrent increase in interest rates to head off inflation have darkened the global economic outlook. But not all countries are affected the same. Asia was initially seen as more vulnerable, since 90% of pre-war Persian Gulf crude exports went eastward. However, many of those countries (China in particular) have shown versatility in securing other sources of crude. This has left Europe more vulnerable to a crude oil supply shock than Asia, as it was already importing as much as it could from the US. EU nations are unwilling to increase imports from Russia, unlike many Asian countries.

Hikes in Europe, Asia Surging

Europe still has an adequate supply of crude in general, but is facing shortages in specific products, such as kerosene used for jet fuel. Europe is also feeling the full brunt of the price increases, and markets are pricing in at least two rate hikes from the ECB in the coming months. The UK is in a similar situation, with the BOE expected to hike between one and two times as well. While this could help support the Euro and pound in the short term, it also means those economies could underperform, dragging down their currencies later in the year.

Meanwhile, the US is a net crude exporter, meaning it stands to see an influx of capital as crude prices remain elevated. While higher energy prices will also have an inflationary impact on the US, the economic effect could be offset by increased exports of petroleum-based products, like chemicals, fertilisers, and plastics. This could leave the Fed in a dovish stance while other major central banks hike rates, further weakening the dollar.

Still Waiting for Confirmation

While the conditions are set for a rally in US equities and a decline in the dollar, there is still some uncertainty in the market. Gold, one of the barometers of risk appetite, has not surged higher yet. The outliers, like bitcoin and tech stocks, are rising, suggesting the recovery may still be in its early stages and that there could be further upside once a final peace deal is hammered out.

Of course, there is always the chance that the Middle East War could flare up again and push down risk appetite. For now, it seems markets are following the usual pattern after entering a correction in March: A summer bull run.