Key Points
- Combined air strikes on Iran by the US and Israel make good media coverage but are unlikely to lead to regime change.
- An Iranian strategy that prolongs the conflict while increasing the cost to the US and its allies has the potential to frustrate US ambitions.
- Rising crude oil prices and increased US deficits will likely fuel a sharp increase in inflation.
President Trump succeeded in diverting media attention from his troubles at home, with attention-grabbing headlines about Operation “Epic Fury” in Iran. But does he have a clear end goal? He claims the Iranians have requested talks, but they deny it. So what happens if the Iranians are unwilling to give Trump his media victory?
Predictions of a “short war” typically underestimate the opponent and the unpredictability of war.
Many things in war are unpredictable, but some are self-evident:
- Israel does not have the manpower to wage a full-scale war against Iran.
- The US public does not have the stomach for a large war, and US leaders want to avoid putting “boots on the ground” at all costs.
- US allies in the Middle East are equipped with modern air defense systems that can protect them from most missile and drone attacks, but they don’t have the stockpiles of weapons to endure a sustained barrage over several months.
- Oil tankers carry 21 million barrels of crude oil through the Strait of Hormuz every day. Four ships have already been damaged. Closing the Straits would halt the flow of 20% of global oil production, causing a massive supply shortage and spike in oil prices.
Brent crude prices shot to above $80 per barrel on Monday.
Robin Brooks compares the current price rise to Russia’s invasion of Ukraine in 2022:
Today’s post …. benchmarks the current shock versus Russia’s invasion of Ukraine four years ago. Russia is a massive oil producer and – at the time – markets worried it would get shut out of the global economy. Yesterday’s spike in oil prices was more than three times as big as the rise on Feb. 24, 2022, the day Russia invaded Ukraine. That’s a big shock no matter how you cut it.
Iranian officials say they have closed the Strait of Hormuz. US Central Command says that is not the case. But tanker rates and insurance costs have skyrocketed.
Lloyds List highlights the steep rise in very large crude carrier (VLCC) rates:
BALTIC Exchange indexes for very large crude carriers loading in the Middle East Gulf reached record highs on Monday. Iranian attacks on tankers and insurers’ withdrawal of war risk cover have effectively closed the Strait of Hormuz.
Spot rate strength in the MEG has cascaded through global freight prices, leading to a surge in rates for VLCCs and other tanker segments worldwide.
The Baltic Exchange’s MEG-China TD3C index went parabolic after the outbreak of war, coming in at a record $423,736 per day on Monday, up 94% from Friday.
Global Impact
China gets about 45% of its crude oil needs from the Middle East, with 11% from Iran.
- Russia, as a large oil exporter, would benefit from a spike in crude oil prices. So would Canada and African exporters like Angola.
- Large oil importers — China, India, Japan, the rest of the Asia-Pacific region, and Europe — would all suffer from a steep rise in crude oil prices.
- The US is a net oil importer. While less affected than other major importers, the US has experienced steep rises in inflation during past spikes in crude oil prices.
The 1973 Yom Kippur War and the Arab oil embargo caused a massive jump in crude oil prices, with CPI reaching 12.0% (red- RHS). The Iran-Iraq war in 1980 caused an even steeper spike in inflation, with CPI at nearly 15%.
During the 1990 Gulf War, CPI rose above 6.0%. However, during the 2003 Iraq War, deflationary forces— from the collapse of the Dotcom bubble and China’s entry into the WTO — helped offset inflationary pressures from higher crude oil prices.
Crude oil prices had already spiked in 2021, but Russia’s full-scale invasion of Ukraine in February 2022 lifted annual CPI to 9.0%.
US Deficits
The US federal debt is at a precarious 122% of GDP, and budget deficits remain stubbornly high. The US does not have much spare capacity to wage an extensive or protracted war without generating high inflation.
Conclusion
China’s dependence on crude oil imports is its Achilles heel. The country imports 11 million barrels of crude oil per day, and much of that flows through the Strait of Hormuz.
Chinese leaders will be watching the US-Iran conflict with alarm. US control of the Strait of Hormuz would have China at its mercy. China’s blue-water navy is decades away from being able to challenge US naval supremacy in the Indian Ocean. The only effective way for them to intervene in the current conflict would be to supply Iran with advanced weapons that can challenge US naval dominance.
The Iranians have been battered by air strikes before. They know that a full-scale US invasion is unlikely, and that nothing short of that will likely remove them from power. Their best strategy is patience. They can afford to wait the Americans out. Increase the cost of the war and frustrate US efforts to achieve a decisive outcome. Another protracted conflict in the Middle East, with sky-high oil prices causing a steep rise in inflation, will soon sour US public opinion and lead to yet another retreat.
A protracted conflict in the Middle East would also increase US fiscal deficits. Inflation will likely rise, fueled by increased government spending and rising crude oil prices. Higher inflation and further increases in government debt would increase term premia on long-dated Treasuries. High long-term interest rates would raise the cost of servicing government debt and further increase the deficit.
Attempts by the Fed to suppress long-term interest rates, through QE or other means, would further fuel inflation.
Our strategy is to remain heavily overweight in gold and defensive stocks with stable income streams, and underweight long-term financial assets and high-multiple growth stocks.
Acknowledgments
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.
