Middle East violence heightens market fears of rate hikes, inflation

TO THE higher-ups at the US Federal Reserve, it must feel like a recurring nightmare: an overseas war driving up the prices of energy and commodities, just when the global financial system needs inflation least.

For investors, the nightmare is made worse by the sense that rescue from the inflationary, post-pandemic bear-market era was tantalisingly close at hand.

The Fed was extending the lifeline of rate cuts, saving them from the rough seas of costly credit, real-estate distress and bank instability brought on by the spike in Treasury yields and other benchmark rates. Now, some economists are even whispering that the Fed’s next action could be a rate hike, rather than a cut.

Safer shores were clearly in view at the last Fed meeting in mid-March. Back then, chairman Jerome Powell was confidently reassuring markets that a 2024 wave of rate cuts was all but guaranteed, despite a wave of robust consumer-spending and gross domestic product growth data.

Then came last week’s March consumer price inflation data, showing a surprisingly robust increase in prices of 3.5 per cent on an annual basis. That was followed by an inflationary geopolitical shock in the form of Iran’s weekend attack on Israel.

By Tuesday, Powell’s tone had changed abruptly; he confessed that the data could force the Fed to rethink its policy entirely.

Markets have been at sea ever since. Banks such as JPMorgan Chase and Citigroup warned of poor visibility and stormy horizons in their recent earnings reports. The International Monetary Fund connected the dots bluntly. If Israel and Iran’s tit-for-tat military actions continue, the conflict is bound to cause an increase in the already-elevated oil prices, which would in turn trigger another wave of inflation, the global lender warned.

After all, war in another oil nation was a major contributor to the 2022 bout of inflation – the price fever that the Fed believed it had broken when it ceased rate hikes in December.

“An all-out war – tanks, hand-to-hand combat, and more large military missiles being launched back and forth – would cause large damage,” said Joe Rinaldi, president and chief investment officer at wealth adviser Quantum Financial Advisors. “You will see a 10 per cent increase in oil. Inflation will increase a little bit, maybe to 4 per cent.”

At this point, he feels there’s only a 10 per cent chance of a full-blown Middle Eastern war. He does believe that Powell has pivoted again.

While Powell has managed the economy and inflation very well in general, the central banker’s actions will be informed by his one major policy mistake, his misapprehension of inflation as a “transitory” phenomenon at the end of the pandemic in 2021.

The Fed was slow to change course when inflation first emerged. Rinaldi said that the pivot this time would be “instantaneous”.

One brokerage said that markets may be reading too much into the March consumer price data. The jump in petrol prices was likely a one-off, reflecting the seasonal adjustments made by refineries. The trends that most worried consumers, and hence the Fed, such as food inflation, have clearly eased, with the prices of cereal and dairy goods, for example, coming down.

“Following the higher-than-expected March CPI (consumer price index), we have pushed back our call for quarterly Fed cuts starting to Jul 31, with risks tilted to the later side,” said economists at brokerage Goldman Sachs in a note to clients. “But we still feel comfortable with the disinflation narrative because of special factors in the recent inflation numbers, well-anchored inflation expectations, and continued labour market rebalancing.”

Petrol prices could jump again, however, now that Israel has launched a reprisal for the shock missile attack from the Iranian mainland. Iran could also choose to use energy as a weapon against Israeli allies, as Russia did against Ukrainian allies back in 2022.

International sanctions on Iran could cause the same price havoc as the recent ban on Russian aluminium, nickel and copper from the London Metal Exchange recently did. Prices of these industrial metals just touched multi-year highs, another sign that inflation could be back with a vengeance. Wholesale inflation moderated in March, but that won’t change. 

 A double-spike in inflation in the space of a decade is hardly unprecedented: there were two spikes in the 1970s, both related to clashes between the West and the Middle East, the Yom Kippur war between Israel and an Arab coalition led by Egypt and Syria in 1973, and the Iranian Revolution of 1979.

In that era, of course, inflation became a self-perpetuating phenomenon as consumers and businesses adjusted their behaviour in anticipation of relentless price increases and had little faith in the Fed solving the problem.

This time around, the stock market, corporate budgets and consumer behaviour suggest that people are looking past a world of high inflation and elevated interest rates.

The stock market’s faith in that future has been rattled by the change in tone from Powell and other Fed officials.

The S&P 500 climbed to new highs in the first quarter because of the impression that the US economy had entered the Goldilocks zone, a place where growth would be hot enough to generate robust earnings, and cool enough for the Fed to bring rates to a benign level. 

Earlier this year, the Fed funds futures markets were pricing in six rate cuts this year, said JD Joyce, president of Houston-based financial advisory Joyce Wealth Management. Now, economists are talking about “somewhere between zero and three cuts”, he noted.

In his view, most investors are missing the silver lining. The uptick in inflation is relatively minor, but it is a very clear indication that the US economy is in hale health, which bodes well for corporate earnings and the stock market, in his view.

Rinaldi, however, is unsure whether that health can survive another spike in Treasury yields, which began after the March inflation data. 

Vacant commercial buildings and efforts by private-equity firms to buy this real estate at a fraction of former values suggests there’s “something deep inside the economy that’s not working”, warned Rinaldi.

The owners of this commercial real estate and their lenders have done their best to keep the financial pain hidden, but another leg-up in credit rates could cause a more public implosion.