About the author: Christopher Smart is managing partner of the Arbroath Group, an investment strategy consultancy, and formerly a senior economic policy adviser in the Obama administration.
The world watched the murder and destruction in Israel with horror last weekend and braced for the suffering of innocent Palestinians caught up in the retaliation. But global financial markets barely moved, suggesting investors are either soulless (often), clueless (sometimes), or just narrowly focused on growth and inflation forecasts that seem unaffected so far (almost certainly).
Markets will surely react to any sign that regional escalation might disrupt oil exports, drive prices higher, and threaten further monetary tightening. But sharp observers will also be looking deeper. Shifts in the tectonic plates that underpin the global economy may produce consequences months or years hence, and as far away as Venezuela and Taiwan.
Had news of the Hamas attacks hit during a busy trading day, investor reaction would have been swift and sharp. Amid instant comparisons to the Yom Kippur War, which included nuclear brinkmanship between Washington and Moscow and an oil embargo that aggravated a global recession, risk assets would have rushed for the safety of dollar-denominated Treasury bills.
With a weekend to digest the news, cooler heads arrived at their desks Monday with a better understanding of the differences in the current crisis. Regional powers showed little immediate appetite for escalation, while today’s Washington-Beijing superpower rivalry barely registers in the Middle East. Through most of the week, Treasuries rallied, stocks rose and Brent crude oil hovered in the mid-80s. Investors took their cues from the vaguely reassuring words in the International Monetary Fund’s freshly issued World Economic Report, which forecasts global growth weakening only slightly next year.
As the Israeli military’s response gears up, the risks of a broader conflict will rise. The barest of improvements in relations between Iran and the U.S. in the wake of a prisoner swap seem sure to unravel, and pressures on Tehran will mount over its longstanding support of Hamas. Plans by Saudi Arabia and Israel to open diplomatic relations are likely on ice. There is little appetite for oil embargoes, but regional producers may prefer to delay any plans to increase production rather than appear to be doing favors for the U.S. as it deploys one, and potentially two, aircraft carriers to the Eastern Mediterranean.
Still, there are reasons to believe key regional players want to keep the crisis contained. While Arab countries immediately blamed Israel’s policies for the Hamas attacks, several modified their initial statements to include condemnation of the killing and kidnapping of Israeli civilians as those details became known. Bahrain, Morocco, Sudan, and the United Arab Emirates all recently normalized relations with Israel under the Abraham Accords. If the violence remains limited the Saudis could still ultimately see recognition as helpful in outflanking rival Iran.
But the real economic consequences of deeply political crises are often only apparent much later and much farther away. North Korea’s missile launches long ago ceased having any impact on global markets, but Pyongyang’s nuclear capacity may prove important in bolstering Russia’s Vladimir Putin as he tries to skirt international sanctions. The S&P 500 posted an all-time high on the day protesters stormed the U.S. Capitol, but that event surely contributed to what Fitch called “an erosion of governance” in a downgrade that may raise U.S. borrowing costs over time.
For all the concerns about this crisis raising oil prices, there are potential dynamics that could actually boost the global oil supply. It’s not hard to imagine an Israeli response that further sours opinion against the U.S., for example, and makes it harder to enforce limits on Russian oil exports. If risks to Middle East oil do rise, Venezuela may find it even easier to secure a deal with the Biden administration to lift oil and banking sanctions in return for democratic reforms.
With the U.S. now committed to supporting two nations at war, speculation naturally rises about China attempting closer control over Taiwan. Beijing already stands to benefit from any tilt in global opinion against the U.S., especially as it welcomes Egypt, Iran, Saudi Arabia and the UAE into the Brics consultations. The trick would be to minimize political blowback, for example, through interference in next year’s Taiwanese elections or a limited embargo on U.S. arms deliveries. But anything that looks like escalation will likely trigger investor fears that the world’s largest bilateral trading relationship is about to unravel.
Most consequential to the world economy, however, would be a protracted Middle East crisis that fuels calls for U.S. isolation. They are already gaining ground over a Ukraine aid package stuck in Congress. So far, support for Israel looks deep and bipartisan, but calls for a less ambitious role in the world may still grow over the next few election cycles and government shutdowns. A U.S. foreign posture in retreat would shake confidence in the global trading system, raise the risks and costs of seaborne trade, and probably fuel regional crises elsewhere.
None of these scenarios—around oil, Taiwan, or U.S. leadership—should be an investor’s base case, but they all deserve a prominent place among the economic risks that could yet ripple out from this week’s ghastly political crisis. Markets haven’t reacted simply because there isn’t enough risk to price in—yet.
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