The Middle East war is escalating at a time when the world economy has just begun to recover its feet.
The US economy grew at a surprising rate, Europe emerged from stagnation and the central banks prepared to relax their policy following two years of fighting inflation.
A conflict which began as an interregional confrontation now tests the fragile progress made.
In real-time, boardrooms, financial ministries, and trading floors recalculate assumptions, knowing that geopolitical risks are rarely confined to a single region.
What is the Iranian economy’s exposure?
Iran’s economy was deeply weakened when it entered the confrontation.
The impact of years of sanctions, currency collapse and inflation was already having a negative effect on purchasing power and investments. In recent reports, inflation is nearing multi-decade-highs. Food prices are also rising triple-digits.
Over the last few years, the rial’s value has plummeted. Capital is flowing into assets instead of productive businesses.
As infrastructure disruptions and financial isolation increase, trade and investment are further restricted.
The economic situation of a country with more than 85,000,000 people and significant reserves of energy is not just stagnant, but could worsen if the instability in that nation spreads.
A prolonged period of turmoil can lead to internal fragmentation and a more rigid state, which both reduce the economic dynamicism as well as foreign engagement.
Investors around the world are concerned about the possibility of domestic instability spilling over into other countries through immigration, regional alliances, and security concerns.
What is the future of global confidence?
Modern economies depend heavily on expectations. When firms are confident in the rules of trade and their ability to hold, they invest. When consumers feel secure about their finances, they spend. Both are complicated by war.
Before the escalated conflict, surveys showed an improvement in business confidence in America and a gradual stabilisation of Europe.
This progress could be halted quickly if the companies put off hiring or capital expenditures.
Geopolitical risks are of particular concern to large multinationals exposed to global supply chain. Costs of insurance increase. The shipping patterns change. Stock buffers are added by firms. Although each decision may seem rational when taken individually, collectively they can have a negative impact on the growth of a company.
The financial markets react often before the real economy.
US Treasuries could tighten the financial climate in other countries. Capital outflows may occur in emerging markets that have weaker currencies.
A higher volatility can increase borrowing costs, both for businesses and government. The financial channel is a powerful way to spread stress, even if there are no physical conflicts.
The pressure on Europe is greater
In the euro zone, the economy has emerged from a weak period. Manufacturing is still well below its potential in many countries and there are fiscal constraints across several of them.
After the shock of the war in Russia and Ukraine, the European Central Bank had set a target for inflation.
The path is complicated by a prolonged Middle East conflict.
In past scenarios, the ECB warned that a disruption of regional activity for a prolonged period could lead to a spike in energy inflation as well as a drop in production.
One severe model showed that the euro zone’s growth dropped by 0.6 percent points, while inflation increased by over 0.8 percent points.
Uncertainty alone, even without the worst-case scenario, can be enough to slow down investment.
The industrial base of Germany remains highly sensitive to changes in global trade and demand.
Tourism and confidence from outside are important factors for the economies of Southern Europe.
If prices rise or the economy falters, governments that have only recently reduced emergency assistance may be under renewed pressure to provide protection for households.
The monetary policy is becoming more complicated. The policymakers need to balance temporary price pressures with weaker economic activity.
The markets have adjusted their expectations of interest rate movements. The ECB will likely proceed with caution, keeping an eye on both inflation expectations as well as credit conditions.
What is the insulation level of the United States?
A large market and greater energy independence are two of the benefits that America enjoys. This provides protection from external direct shocks. Insulation is different from immunity.
As the US economy entered this year, it was characterized by strong employment markets and improved corporate sentiment.
While business surveys indicate that capital spending has increased after a cautionary period, an ongoing geopolitical crisis can cause hesitation. Uncertainty about global trade, political instability or demand can cause firms to pause their expansion plans.
Federal Reserve faces an equally narrow road. The Fed could delay its easing if global factors cause inflation to reaccelerate.
The Fed took an initial cautious approach during Russia’s invasion in Ukraine before tightening its belt as the inflation rate soared.
Now, policymakers will monitor whether the price pressures go beyond headline figures and if financial conditions are tightening materially.
US growth will remain largely unaffected by a short conflict. Pessimistic scenarios include the possibility of prolonged regional instability, wider trade disruptions, and increasing fiscal costs.
The US economy could be affected by a significant slowdown, while the rate of unemployment could increase from its current low level.
Risk of layering shocks
A single conflict will rarely be decisive in an economy worth $100 trillion. It is the accumulation that concerns us.
The backdrop is already complex, with trade tensions, changing tariff policies, volatility in the financial markets linked to sectors of technology, as well as high levels of public debt.
They can reveal hidden vulnerabilities when they overlap. Stress increases the vulnerability of private credit markets, leveraged balance sheets for corporations and stretched fiscal situations.
Additional risks include insurance costs, cyber threats, and proxy wars in the region.
Uncertainty over both time and space is increased by a protracted, asymmetrical campaign. Some strategists believe that this scenario will be more probable than a conventional short war.
Central banks are more credible today than they were in the past, as global economies use less energy.
The interconnectedness of supply chains and the financial markets can cause investors to lose confidence quickly, if they perceive that escalation is not capped.
The macro-outcome is determined by the duration
The majority of forecasts are based on the assumption that conflict will be limited and short.
According to this assumption, global growth will be modest and inflation pressures temporary. Central banks are expected to remain patient.
The consequences are worsened if the conflict continues for several months, or reaches other regions. The investment slows down. Rethinking fiscal plans by governments
Risk premia are increasing in the financial markets. The central banks are forced to make difficult choices between price stability and growth.
Currently, markets are focusing on price containment.
This judgment is based on the assumption that an escalation won’t spiral out of control and that politicians will take action to avoid severe economic damage.
Investors pay attention to headlines, as well as indicators such credit conditions, policy responses, and confidence.
How long the uncertainty lasts, and how well institutions are able to absorb it will determine how much of an impact on economic growth we can expect.
The post Iran Conflict and the US Economy may change as new information becomes available.
