We are now 5 months into this “4-week war”, and my thesis remains the same. Iran is not interested in a deal. They want to teach the world, especially the US, a lesson. If you attack us, we will choke off the world's oil and gas supply and bring your economy to its knees.
What does that look like? At this point, the most likely outcome is an energy shock that morphs into a growth shock and quite possibly a global recession. Their playbook takes a leaf out of the 1979 oil crisis. But the worst-case scenario could be far more severe.
How severe will depend on how far Iran wants to take it. That's the key point, and it is why I am especially cautious at the moment from an investment perspective. Where this goes next might well be out of the hands of the US and the rest of the world. Iran appears to hold the strategic initiative.
The 1979 oil crisis led to the recessionary environment of 1980-81. Back then Iran stopped producing oil for about 8 months. It amounted to around 5%-10% of global supply. Yet today by closing the Strait of Hormuz, they can disrupt around 20% of the global oil supply and almost 20% of global LNG trade.
How could it be worse? Well in the past week or so the Houthis of Yemen, who are aligned with Iran, started attacks on ships in the Red Sea. This is a significant potential escalation and brings into question whether the Bab-el-Mandeb Strait will be next to close.
If the Houthis close this Strait, it not only puts more pressure on the supply of oil but also a range of other cargo. Bab-el-Mandeb accounts for around 12% of global trade as it leads to the Suez Canal and is the gateway to Europe from the Middle East.
All of this demonstrates just how little control the US really has over the current situation. I think it is unlikely military action alone will deter Iran. They are fighting a completely different war to the one the US thinks it is fighting.
So, what is next? Again, this depends on Iran and its allies. Saudi Arabia has a 1,200km pipeline that was built to bypass the Strait of Hormuz to help in a situation just like the one unfolding today. My concern is that the next phase of escalation in the months ahead is focused here.
If Iran's strategy is to create prolonged disruption and uncertainty both geopolitically and in financial markets, then attacks on infrastructure including this pipeline are possible. That will come with its own set of risks by way of response from the US and its Gulf allies.
The rest of the world is watching too. There are many chokepoints around the world that are critical to global trade. There’s the Suez Canal in that same region, but then there’s the Strait of Malacca in Asia which sees 25-30% of global trade pass through it as well as the Taiwan Strait and the South China Sea.
So how the fight for control of the Strait of Hormuz unfolds will be strategically important for many other regions. There are precedents being set here that will reverberate around the world depending on the outcome and who manages to wrest control of the waterways.
In its simplest form, for now, this starts as an energy shock. But that is just the beginning. There are multiple flow-on effects. If the disruption does persist, the price of oil and gas will skyrocket. That will quickly flow through to higher fuel prices, renewed inflationary pressure, and a further increase in the cost of living.
The increase in prices hurts everyone from consumers to businesses. Higher inflation presents a major problem. Not only as costs increase but because there are implications for interest rates. Higher inflation puts pressure on central banks to raise interest rates.
That is bad enough, but an energy shortage means there simply isn’t enough. Paying more for the commodity doesn't create more of it. There is no alternative. Less energy means less of everything. Less production, less output. Unavoidably economic growth takes a hit.
This is where the real flow-on effects occur; higher costs meeting slower growth or even negative growth. When these forces converge, the risk of a global recession rises materially. Then there is nowhere to hide. The global economy slows, the share market falls significantly, businesses lay people off, unemployment rises, and consumers stop spending.
The longer this remains unresolved, the greater the probability that this scenario unfolds. It is a scenario we have been preparing for and one where the downside risk is potentially much more serious than the market is factoring in. At a stage in the market where many sectors are priced for perfection, the reality unfolding is very different. We will continue to take profit and build a cash war chest.