There is a considerable gap between what are considered to be the geopolitical ramifications of the escalating tensions between the US and Iran since the start of the year and the subdued reaction of markets. The market reaction probably reflects the investors’ view that the probability-weighted impact on growth should be very limited because the risk of a major escalation is considered to be small and/or because of an expectation that the impact of higher oil prices on the economy is limited. What also may play a role in the market reaction thus far is that, leaving the geopolitical uncertainty aside, the economic environment is considered to be conducive to taking risk: stabilisation of survey data, reduction in trade-related uncertainty and accommodative monetary policy.
Compared to the analyses from political commentators of the escalation of tensions between the US and Iran since the start of the year, the market reaction has been very subdued. It is tempting to call it an example of irrational complacency, based on a view that risks are being underestimated, although the opposite interpretation can also be defended: what, at first glance, looks like complacency, could be a reflection of rational pricing of uncertainty.
The economic consequences of geopolitical uncertainty[1] are complex and varied. The transition to a regime of higher uncertainty can end up weighing on growth, notably via slower growth of corporate investment. This effect takes time to materialise because it depends on how quickly companies become convinced that the higher uncertainty is there to stay and that it influences their business. Uncertainty spikes, which are short-lived, can trigger knee-jerk market reactions whilst having limited or no lasting consequences, neither on markets nor on the economy. A key question is how exactly uncertainty influences the economy: which variables are impacted in the first place and how do they, in turn, influence production, inflation, spending, interest rates, etc? In gauging the consequences of the confrontation between Iran and the US, oil prices play a key role as a channel of transmission considering that an escalation could end up causing supply disruptions. It is worth recalling the developments in August 1990 when the invasion of Kuwait by Iraq caused a doubling of oil prices within three months. After having peaked in October that year, prices stayed at a high level for several months and only approached their pre-invasion level in the spring of 1991. Hence, it makes a big difference whether an oil price increase is short-lived (because disrupted supply can be restored very quickly) or more lasting.
Bringing this all together, investors and company managers need to answer several questions in deciding on how to react to the recent increase in tensions: a) will they continue to escalate? b) will it end up creating oil supply disruptions? c) if so, what would be the impact on oil prices? d) would this impact be very temporary or last for several months? e) how would economic activity react? f) could the reaction be of such a nature that a recession would follow? In such a scenario analysis, the growth impact at the end of the decision tree is equal to the product of the values in decision nodes a) to f).
