Geopolitical events and the economy

Spotlight: Geopolitical events and the economy

Geopolitical events are significant occurrences that impact the political, economic, and social relations between countries. Such examples include territorial disputes, diplomatic negotiations, military alliances etc. These events shape global politics and can have far reaching consequences on international relations. In the news this week was the anniversary of the start of the Israel-Hamas conflict. The situation in the region remains uncertain and there are questions starting to be asked on the potential escalation in the region. The international community continues to call for a resolution to the conflict and humanitarian aid for those affected. We focus in this piece on the impact of geopolitical events on the global economy.

The overarching message is that so far conflict in the region has not materially impacted the global economy or capital markets so far. When evaluating geopolitical conflict and its impact on the economy, it is most useful to start with the markets that are closest to the conflict itself. In this case, this means looking at oil markets, natural gas markets, and currencies such as the Israeli Shekel and Saudi Riyal (which is pegged vs the US Dollar meaning its value rises and falls with the Dollar) for any excessive strains. The Brent oil price was at around $90 a year ago and has generally traded in a range centred on $80 since then. The price was $81 as of 7th October 2024 – exactly a year on from the start of the conflict. Market analysts see the fair value of oil to be around $75-80 given various supply and demand dynamics, source WTW. So right now, the oil market looks reasonably balanced between supply and demand, with some spare capacity still. A few short-term points of Middle East geopolitical driven market movements have occurred in the last year – the risk of the Strait of Hormuz being blocked by Yemeni rebels, and the more recent direct military action between Iran and Israel, but so far these have been short-lived and hence the impact on markets has been minimal. Natural gas markets since the start of the war, for example, the EU TTF (which serves as a proxy for natural gas prices in Europe) tells much the same story, see chart below.

For a geopolitical event to cause a lasting shock to major economies and financial markets, you need a fundamental impact (for example a material effect on supply or demand). So far, we have not observed such an impact. Although further escalation might threaten Iranian oil supply, its global share as a percentage of world oil supply is small and could be compensated by increased production from Saudi Arabia or other sources. Comparing oil and natural gas price trends over the past year with those over the last five years highlights this. To put it into context, the Middle East events have had limited fundamental and price impacts when compared to the significant disruptions to European natural gas, agricultural products, and global oil caused by the Russia-Ukraine conflict.

What does this mean for portfolios?
Events in the last few weeks in the Middle East region have increased concerns around the risks of further escalation. However, a material escalation that significantly impacts the global economy and capital markets remains a tail risk (a rare and extreme event that can cause large losses) in our view (source WTW). The best portfolio response is to build a robust and diverse portfolio by sectors (e.g. healthcare), asset classes (e.g. bonds) and geography in order to achieve better long-term performance and use downside risk protection against tail risks as appropriate. 
 

The Noise

• The UK’s GDP rose by 0.2% in August, signalling a positive shift in economic growth for Q3. This follows a period of stagnation in June and July, when growth rates flatlined at 0%. Though the Office for National Statistics identified that all major sectors were growing, there was weaker than expected growth in the services sectors, which was offset by a strong rebound in production and manufacturing. This has not changed the view on the likelihood of the BoE cutting interest nates in November, the expectation remains that they will cut them by 25 basis points. Looking ahead, this growth is encouraging as the Labour government prepares to announce its Budget at the end of the month, emphasizing economic growth as their top priority. However, they have cautioned that achieving this growth may require some ‘painful choices’ in the Budget.

• British shoppers have increased their spending this September, with national demand for entertainment skyrocketing by 14.4%. This surge follows the announcement of the iconic UK rock band Oasis’ reunion. Such a rise in the entertainment industry comes as no surprise as some of the biggest music stars return to touring after COVID-19. For instance, we saw that Taylor Swift’s ‘Era’s Tour’ had a significant economic impact on the cities she performed, directly channelling funds into local businesses and communities. With live entertainment making a continued comeback we can anticipate increased consumer spending, despite lingering concerns about potential tax rises.

• This week Britain took a big step towards its long-term renewable energy goal, which aims to fully decarbonise the power sector by 2035. The country’s last coal-fired power station shut this week at Ratcliffe-on-Soar; a known landmark to many when driving up the M1. This speaks to the wider trend of abandoning a fossil-fuelled grid, with renewables jumping to the majority share (51%) of UK electricity last year. Yet not everyone is following the government’s footsteps. BP, one of Britain’s largest energy companies, announced it was abandoning its goal to cut its oil and gas output by 25%, in an effort to regain investor confidence. This is the second time they have cut back on their decarbonisation commitment since 2020. Looking ahead, we can see that Britain’s energy transition is at a crossroads, finding the balance between both investor satisfaction and renewable energy goals.

The Numbers

The Nuance

With the Federal Reserve’s highly anticipated first rate cut now out of the way; attention is now shifting to its upcoming meeting. We won’t hear from Chair Jerome Powell until the November 7th meeting, with the latest interest rate decision likely to be announced with the US presidency in limbo. In the meantime, we can follow the lead of the Federal Reserve and focus on the data. A surge in US job growth last week saw financial markets taper bets of another mega-sized rate cut in November, while leading some to speculate if the policy rate will settle at a higher level than previously expected.

Weekly unemployment claims this week jumped by 33,000 to 258,000, 25,000 higher than expected. Ongoing claims are also higher than expected, though the impact of strikes at Boeing and Hurricane Helene have muddied the waters. Markets have thus found it difficult to draw any meaningful conclusions. The labour market’s outlook through the end of the year is also likely to be distorted by Hurricane Milton, which whirled through Florida this week. 

Turning to inflation, US consumer prices rose slightly more than expected in September, with CPI rising 2.4% year-on-year. Month-on-month CPI climbed 0.2% from August, boosted by housing and food which accounted for over 75% of the increase. Following the data, US equities fell, with the US dollar appreciating against a basket of currencies. US Treasury yields also fell, increasing prices.

The higher-than-expected inflation figures, along with last week’s blowout jobs report will likely strengthen the debate on where the Federal Reserve will land at next month’s meeting. The likelihood of a 25bps cut has grown considerably over the past week at the expense of expectations of a second consecutive 50bps rate cut. Though with four weeks still to go, there is still a lot of room for all of this to change.