As the Middle East stalemate drags on, so the economic pain will continue to build

Time to prepare, not panic

With the stalemate in the Middle East continuing to render the Strait of Hormuz closed, growing inflation worries have continued to put upwards pressure on fixed income yields over the past week. Benchmark Brent crude futures have risen back to $115 per barrel.

Meanwhile, a broadening understanding that supply chain disruptions will continue to plague the physical market for months to come, even under the market embedded assumption that we will soon see a re-opening of the Strait to traffic, has seen 6-month Brent futures rise above $90 per barrel, a new high since the inception of the conflict. Global central banks remain on high alert with respect to upside inflation risks, though policy meetings across the G7 saw rates maintained on hold for the time being.

With supply chain disruptions starting to impact economic activity, growth forecasts are being revised lower as quickly as inflation forecasts are being revised higher, and this creates a sense of tension with respect to policy objectives.

Since monetary policy actions are assumed to operate with relatively long lags, doves will argue that it makes sense to look through near term inflation, as long as inflation expectations can remain contained and there is limited evidence of second round inflation effects. However, remembering Jay Powell's famous error back in 2021, when the Fed Chair characterised rising inflation to be purely transitory, it is understandable that materially higher CPI prints cannot be ignored, even if there is an expectation that prices will begin to recede once supply chain disruptions are normalised.

That said, in the case of the U.S., the bar to hiking rates is likely to be elevated with Kevin Warsh taking the helm of the Fed. However, we remain sceptical that there should be any reason to debate policy easing any time soon, and so we expect the FOMC to remain on hold for the foreseeable future. Meanwhile, it seems that life for Warsh may be complicated by Jay Powell retaining his seat as a Governor, even after standing down as Chair, until the Trump administration's investigations into the Federal Reserve have been fully closed out to Powell's satisfaction. At a time of unanimity within the Fed, it is unlikely that the presence of the former Chair would undermine Warsh's authority, but the new Chair takes office at a time when the current Fed is very divided in its view, and this could make his transition bumpier than otherwise would have been the case.

Meanwhile, in the Eurozone, we expect the ECB to hike in June and September, given the singular objective of the institution with respect to price stability. However, in the wake of a downbeat growth outlook, it wouldn't be surprising if these moves are subsequently reversed in 2027, and this factor should help to limit a further sell-off in short-dated yields.

In the UK, an inflation overshoot may see CPI above 4% in the coming months. This may also see the Bank of England forced to hike rates. Yet given that Governor Bailey already saw plenty of slack in the economy, this infers that the BoE may be able to bide its time for a while longer. However, at a time when both the growth and inflation outlooks are being revised in the wake of the Middle East conflict, for now, it is the latter which is having the biggest influence on bond yields.

Curves on both sides of the Atlantic have been bear flattening, though it is not clear how much longer this trend will persist for. In many respects, as we meet with global policy makers, we are struck that at a time of elevated government debt levels around the globe, there is a subtle shift in attitudes with respect to the growth/inflation trade off, which may ultimately end up favouring slightly higher inflation as long as this is accompanied by more robust economic growth.

This is seen in questions around central bank inflation targets and in this respect, were the Fed to switch from a focus on PCE inflation to a trimmed mean measure, this could infer that actual CPI in the U.S. normalizes around 3% going forwards. Prime Minister Takaichi in Japan has spoken about her desire to maximise nominal GDP, and even in the Eurozone there seems a growing appreciation that in the absence of supporting growth the whole region could face a much more sclerotic future, which may be even more damaging for long term future price and financial stability.

Reflecting on this, we are inclined to think that yield curves will ultimately start to re-steepen on both sides of the Atlantic in months to come. However, in wanting to position for this, we think that the best way to add risk in fixed income at this moment is through positioning in inflation-linked bonds. In this context, we think that a larger inflation overshoot is the principal threat to higher short term yields. Moreover, absolute levels of real yields appear to be attractive in the U.S., Eurozone, and also in Japan.

We remain more wary of adding risk in the UK, as we see upcoming political risk coming from a move to replace Starmer, as a potential catalyst for further volatility in long dated yields, especially with Burnham wanting to advance his credentials. Indeed, moves by Burnham may act to accelerate a push from Angela Rayner in the next couple of weeks and we doubt that Starmer will have much time left as UK Prime Minister.

Elsewhere in markets, even as the Strait of Hormuz remains blocked and economic concerns continue to build, we are struck that European credit spreads remain resilient, with the Itraxx Crossover index at a spread of 295bps compared with a high of 362bps at the end of last month, when crude oil prices and German bund yields were last at this level. This determination to shrug off bad news has been impressive, and we feel that much of this has been related to resilience in the S&P in the U.S., where the index has continued to make new highs on the back of strong earnings and retail participation continuing to chase stock prices higher. Yet what matters in credit is potential default risk and prospective recessionary risks don't seem to have been taken very seriously at this point. In this respect, we would note that the Itraxx Crossover index traded at a spread above 600bps during 2022 when such fears were last manifest, with spreads not moving below 400bps until late 2023, once these concerns had materially diminished. This speaks to an element of complacency from our point of view, with risks to spreads in the region asymmetrically skewed to the upside at this moment in time.

Of course, a breakthrough in U.S-Iran negotiations remains possible in the days ahead, though in the short term it might appear that the two sides remain far apart and aren't subject to sufficient discomfort to drive a compromise just yet. In the U.S., we are keeping a close watch on average gasoline prices, which have been stable around $4.80 per gallon over the past month, compared to a level around $3.60 prior to the start of the conflict.

However, the protracted stalemate is likely to see $5 breached before long and were gas to head towards $6 later this month, then this may be the most important factor in pushing the U.S. to give ground to Iran. In Iran, pain will also start to accumulate as storage capacity runs out and the flow of money to support the military starts to dry up. However, with the centre of power in Iran seemingly in the hold of the hardliners within the IRGC, it may be seen that the tolerance to endure discomfort is more embedded in Iran than is true for the United States and a notoriously impatient U.S. President.

However, the idea of the U.S. agreeing to re-open the Strait under Iranian supervision, with Tehran empowered to impose levies on traffic remains an anathema to the U.S. and many of the Gulf States. Other countries might willingly accept the notion of a $1 toll on every barrel of oil, if only it can mean peace is achieved.

Yet by empowering Iran in this way, this may mean even more cash to fund Iran's military and an even more repressive and ideological regime. Consequently, it is understandable that Israel, the UAE and others are desperate for a resumption of a military campaign to finish the job, for fear of a more unpalatable future in their neighbourhood. Indeed, the UAE's break with OPEC this week can also be seen in this context. Yet, the risks from a renewed military intervention are significant and may not be appealing to the Trump administration. Therefore, the idea that stalemate can persist would appear the most likely outcome for a little time yet. Ultimately one side is likely to blink, but there is no clear sense of this for now.

Elsewhere, focussing on Japan, the BOJ mirrored other central banks by maintaining policy on hold this month. A rate hike in June remains likely, though with Takaichi retaining a dovish stance, it is unclear whether she will continue to prevail on the BOJ to defer policy tightening. Intervention on the yen, as it breached 160 versus the dollar saw a swift move down to 156. Yet if this is seen as removing pressure on the BOJ to move, then this could see the yen return to this intervention level. We retain a small bullish stance on the yen. Ultimately, we might want to adopt a larger risk position, but to do so we want to feel more confidence that BOJ policy will help sustain an up move in the value of the Japanese currency.

Looking ahead

The standoff in the Middle East is set to continue to dominate the backdrop in global financial markets for the time being. In commodity markets, inventory levels are being drawn down, but demand destruction will need to occur relatively soon in order to bring demand and supply into a sustainable balance.

From this standpoint, indices tracking global air traffic show flights down around 5% from 2025 levels at the current point in time, and we would think that a further 10% curtailment may well be necessary in the weeks ahead. Jet fuel prices close to $200 are more than double the level that traded back in January and although potential fears that European airports would run dry have been allayed thanks to imports from the U.S., there is a risk of a further move up in prices, which will trigger further reductions in flight schedules.

Higher airfares will be a material component of higher CPI prints over the coming month, and we also expect to see price hikes show up in a range of other goods prices. Furthermore, we continue to highlight the risk of the U.S. moving to restrict the export of refined products if shortages drive U.S. prices materially higher, knowing that the U.S. administration won't be shy when it comes to advancing an America First agenda.

Looking at markets, we see an opportunity to position slightly short of risk assets on a net basis, looking to generate returns on the short side from wider spreads. We also see opportunities in inflation-linked bonds, as we feel the full extent of the inflation (and growth) shocks we are witnessing have yet to be fully understood in financial markets.

In a way, when reflecting on the current situation, we are reminded of early 2020, when we were reading about the nasty Wuhan virus that was spreading inevitably our way. Yet, in January and February of that year, equity markets recorded new record highs and we continued to party on regardless. Subsequently, it was only when the reality of the Covid shock impacted our day-to-day lives, that everything changed and markets subsequently adjusted. This said, we are not claiming the current energy supply shock is anywhere near the same in magnitude as was Covid. However, it is still very significant.

From an energy supply perspective, voices such as the Executive Director of the IEA have already declared we are living through the biggest energy security threat in history. This seems to be something seen by those closest to ground zero, in the same in the way that healthcare workers were the first to understand the true threat which Covid would ultimately become.

We are not arguing at all for panic. However, we are sounding a warning against complacency and the need to ensure we are well prepared. There will be plenty of opportunities to monetise in the months ahead. There will also be shocks to avoid, in order to ensure losses are not incurred.

It isn't quite time to rush out of the house and start bulk buying toilet paper, but this is a moment when risk beta should be held at modest levels. There is an adage in the UK about sell in May and stay away. This year that does seem to be a metaphor that may well ring true….

^{* The information contained in this material is correct as of the publishing date of this article and is subject to change frequently.}