Will the Middle East crisis trigger a global “hard landing”?

•  The escalating conflict between Israel and Hezbollah is the latest geopolitical risk to undermine global markets. Indeed, some commentators have speculated that the impact on oil prices could be the trigger for a global “hard landing”. That is overdone. Nonetheless, the markets are right to worry about downside risks to world growth in the next year or so, even if they are looking in the wrong direction.

•  The images of the tragic events in the Middle East may well be shocking, but they have no direct impact on day-to-day economic activity elsewhere. The one tangible effect is the additional upward pressure on oil prices. However, as the first chart shows, this continues a trend which has been in place since early 2004: global growth was relatively strong throughout this period at the same time as the oil price regularly set new highs.  One can argue about exactly how much of a risk premium the latest events have added to the oil price, but supply concerns would not have had such an impact if underlying demand had not also been firm. The bigger picture is still that, while higher energy costs are a significant threat, it is arguably the current strength of the world economy is driving oil prices rather than the other way around (although watch this space!).

•  Admittedly, the short-term risks to oil prices are clearly skewed to the upside. The geopolitical uncertainties and the recent upward trend in oil prices mean that it is hardly a brave call to talk of Brent hitting $80 or even $90 per barrel soon. But to put this in context, oil prices have already risen from $26 in late 2003 to around $76 today: it is hard to see why another $5-10 per barrel should make that much difference when the world economy has already weathered an increase of $50.

•  Of course, things could be different if the conflict was to spread across the region, and oil prices spiked above $100. However, this would be very much a worst case scenario. Simple geography suggests that if the conflict does spill over into other countries, it is much more likely to drag in Syria than Iran. This could still have some important repercussions, but Iran is by far the more important oil producer (as well as the greater military threat). What’s more, there are several precedents where Israel has attacked militant targets or civilian infrastructure in Lebanon (notably in 1993 and 1996), with little international fall-out. Unfortunately, these sorts of episodes are “business as usual” in the region.

•  It has also been said that the impact of higher oil prices on headline inflation means that central banks will now move into monetary “overkill”, raising interest rates aggressively. However, financial markets have focused more on the risks to growth than inflation (witness the recent falls in bond yields), and one can expect central banks to take the same view. Core inflation remains generally subdued, aside from the atypical impact of higher rents in the US. Indeed, global interest rates are probably now close to their peak and could be falling within a year (see Chart 2), as the cooling housing market in the US leads a global slowdown.

And finally…………

Scenario:

You are driving in a car at a constant speed.

On your left side is a valley and on your right side is a fire engine traveling at the same speed as you.

In front of you is a galloping pig which is the same size as your car and you cannot overtake it.

Behind you is a helicopter flying at ground level.

Both the giant pig and the helicopter are also traveling at the same speed as you.

What must you do to safely get out of this highly dangerous situation?

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Answer:

Get off the children's Merry-Go-Round, you're drunk!

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.