While markets remain optimistic that President Trump will find a way to get Iran to reopen the Strait of Hormuz, the longer this goes on the more concerning this becomes a global economic catastrophe.
In the past, such as the introduction of tariffs in April last year, Trump has managed to push and pull the information flow to address problems as they escalate. This time he is trying to do the same, but he is learning the hard way that Iran was in a stronger position than he realised.
From an investors perspective this situation needs to be fixed quickly. The global economy needs the Strait of Hormuz to be reopened urgently. For Trump to do this it will require either massive concessions from the US via negotiations, regime change or a significant escalation.
The military might of the US is not in question. But Iran is clearly in control of the Strait of Hormuz. Trumps rhetoric around winning the war and ongoing negotiations with Iran seems to have placated investment markets so far. Markets are down slightly. But there is a general expectation that Trump will get a deal done, the Strait reopens and away we go. The concerns for markets will be if they stop believing Trump and realise that if he could have reopened the Strait by now, he would have.
If the Strait of Hormuz takes weeks or even months to reopen, then we are in for a severe 1970’s style energy shock that will reverberate through the global economy. In that situation you get rising prices across energy and food, interest rates rising, slowing global growth, falling company profits and rising unemployment.
In the late 1970s and early 1980s in the United States, oil prices more than doubled, inflation pushed above 13%, interest rates peaked near 20% under Paul Volcker, unemployment rose from around 6% to over 10%, and equity markets delivered negative real returns of roughly 50% over the broader period. In Australia, and across much of the world, the pattern was the same, high inflation, rising unemployment and weak real returns.
There is so much more downside risk than upside opportunity in the share market right now. The S&P500 and ASX200 are both down a little over –7% from their highs. So, if everything is reopened tomorrow that’s about the extent of your upside. But if this drags on the downside is significant, easily another –10% to –20% or even more. A global recession would wreak havoc with the economy and the share market. And the longer this goes the more likely that is.
Markets are underestimating the level of control the US has over this situation. But they are also underestimating the supply chain and second order effects. Investors have become so conditioned to the market recovering quickly after a crisis and buying the dip that they underestimate the potential of something deeper.
I usually describe myself as cautiously optimistic. However, as more time passes my approach is becoming increasingly cautious and far less optimistic. If Trump somehow conjures a deal, the US facilitates regime change or Iran willingly reopens the Strait of Hormuz, then markets will celebrate and away we go. But in the absence of the Strait reopening then markets will quickly adjust for what is ahead. As we’ve seen repeatedly in recent years, markets don’t price risk like they once did, they move once an event occurs. From here, outcomes for markets diverge sharply depending on what happens next. That’s the gap investors should be thinking about.
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