Introduction

The past week provided welcome relief in the Iran War, with Trump delaying for two weeks his threat of the “complete demolition” of Iran’s power plants and bridges. So far its all very shaky, but whether the “ceasefire” holds or not and the War de-escalates or escalates from here, there will be significant long-term implications, beyond the near term stagflationary impact that already looks likely this year. The long-term implications will mostly serve to reinforce existing trends towards deglobalisation, increased geopolitical risk, even bigger government and higher inflation pressures.

TACO time – the current state of the War

Trump’s decision to backdown and announce a ceasefire was consistent with his pattern of making exorbitant demands then backing down as pressure grows intense. This time around his poll support was collapsing, markets were threatening to riot, and he was in a no-win situation with Iran. It clearly has plenty more missiles and drones and, if he escalates, it would use them, worsening the global impact. While Trump has military superiority, Iran has weaponised the Strait of Hormuz to control global oil supplies. So, it is a sort of MAD – mutually assured destruction – stand off from which Trump ideally has to back down. Renewed US/Iran talks have failed to reach agreement, with Trump declaring “whether we make a deal or not makes no difference to me. And the reason is because we’ve won”. But then he announced a new contradiction – the US will itself block shipping in the Strait, but at the same time its Navy will begin demining it! Of course he may soon say something completely different. Overall, we lean to the view Trump will find a way to keep the ceasefire going given the political pressure he is under, but uncertainty is high.

For now, the Strait remains the key, because the last ships that made it through at the end of February are now reaching their destinations meaning refineries in Asia will soon start to run low on oil to refine. So the resultant 10-15% hit to global oil supply (after allowing for diversions, eg, via the Saudi East-West tunnel) will start to bite this month. All of which risks a renewed surge in oil prices – to maybe around $US150/barrel in order to curtail consumption – and plunging share markets.

The nascent pick up in the flow of shipping could resume. But if this comes with Iran and/or the US controlling the flow (with fees and vetos) it will be an unstable solution – as the rest of the world won’t accept such an outcome indefinitely, given the precedent it will set. This would point to a resumption of the conflict. Maybe after the midterms are over, when Trump is less politically constrained, or if his and Republican polling gets so bad that he has nothing to lose by escalating again.

Even if there is a quick end to the War it will take months for global oil flows to return to normal given the time it will take to resume energy extraction in the Gulf (weeks & months for oil, years for some gas plants), to then load this on to ships and for those ships to arrive at refineries in Asia. And then for the refined products to reach Australia.

So, a near term stagflationary impact of higher inflation and weaker growth is now baked in. In Australia, we see inflation peaking around 5-5.5% in the current quarter and GDP growth slowing to around 1.5% this year. With oil supplies coming to crunch time this month the risk of recession in Australia is now high. For central banks wary of letting inflation expectations rise, the focus is likely to be initially on the boost to inflation rather than the hit to growth. This is the case in Australia where inflation was already well above target and signs of rising wage demands will worry the RBA. So, we are allowing for more RBA rate hikes this year.

The longer-term consequences

Beyond the uncertain short term stagflationary impact the War will leave a longer-term impact on economies and markets in nine key ways.

1. Higher prices, inflation and inflation expectations – having another hit to supply and boost to inflation so soon after the last one in 2022 and on top of the tariff impact in the US will lead to another leg up in prices. This runs the risk of a further boost to inflation expectations and loss of faith in central banks’ ability to get inflation back to target.
2. Increased geopolitical risk – this has been on the rise ever since the 2010s due to a loss of faith in liberal democracy reflecting rising inequality, increasing nationalism and populism and a shift away from a unipolar world (dominated by the US) to a multipolar world. The US has gone from chief defender of liberal democracies to a force propelling this shift under Trump with his focus on doing what he wants for America, trashing the global rules-based system, attacking allies (and treating them as scapegoats for his mistakes on Iran) and acting like a “madman” which is leading to a loss of credibility for the US. This has been particularly evident this year with the US intervention in Venezuela, attempt to take Greenland (which he is still on about) and now Iran. It’s hard to see this not being interpreted by other powerful countries as a green light to do whatever they want in their region and beyond. I would rather Ray Dalio’s assessment that the world is heading down a path that risks broader conflict be wrong, but it can’t be ignored. What’s going on now with Iran is the sort of thing that world wars start over.
3. A new generation of terrorists – the Israel/Gaza war and now the Iran War risk driving a renewed rise in terrorism. Economies and markets can look through terror attacks that are limited in impact – as we saw in the 2000s – but this would change if the damage was more general.
4. Increased defence spending – this is an inevitable result of increased geopolitical risk. It will also be fuelled by Trump’s renewed contradictory attacks on NATO countries and other allies including Japan and Australia – for not joining in on the attack on Iran. Particularly so if the US decides to leave NATO as it’s been alluding to.
5. Increased spending on oil and gas infrastructure – while Trump appears to have been surprised and frustrated by Iran’s move to control the Strait of Hormuz (through which 20% of global oil and gas flows) as evident in his “Open the F…… Strait, you crazy bastards” comment, it’s entirely logical and had long been predicted if Iran found itself threatened. It was why Saudi Arabia built its East-West oil pipeline in the 1980s. Now that it’s happened, it provides yet another reminder of the global energy dependency on a highly volatile part of the world. This was on display in the 1970s but was forgotten about from the 1980s as oil shocks were brief. It’s likely to mean increased efforts by Gulf countries to bypass the Strait and medium term moves by other countries to boost their own oil and gas reserves.
6. Increased focus on renewables and nuclear energy – over the longer term the crisis will further boost demand for renewables and nuclear on the simple logic that the sun, the wind and nuclear energy do not depend on volatile politics in the Middle East. This is already evident with motorists reportedly scrambling to buy electric cars (which are now around 15% of new car sales in Australia).
7. Yet more pressure to onshore supply chains – this is on top of the pressure flowing from the pandemic for medical equipment but will now focus on oil refining, aluminium, fertiliser etc which are all being impacted by the War. Future Made in Australia will likely see another leg up. Which all means more protectionism and deglobalisation.
8. Yet another reminder that it’s now a more crisis-prone world – the Iran War is now the fifth major global shock in the last 20 years with the others being the GFC, the Eurozone debt crises, the pandemic & the 2022 inflation shock. While there were crises before that – the tech wreck, the Asian crisis, the early 1990s recession – they now seem more frequent & less related to traditional economic cycles.
9. Bigger government and more public debt – more defence spending and government involvement in economies, eg in onshoring, mean more public spending, bigger budget deficits and ever higher public debt – at a time when its already high. The latter is particularly evident in the US with Trump pushing for a $500bn (or 42%) defence budget boost when the US budget deficit is running around 6.5% of GDP despite low unemployment suggesting it should be in surplus.It could also be evident in the upcoming Federal Budget in Australia, which is likely to see more “cost of living” help for households and business at the expense of commitments just a few months ago for the Budget to focus on savings in the level of spending and on productivity enhancing reforms. Another year of stronger spending growth will add to concerns that it will never be brought back to more sustainable levels, as in 2027 the focus will return to the next election.Ever higher public debt and rising bond yields also run the risk of a public debt crisis at some point.

Implications for investors

There are three key implications for investors.

First, a somewhat less favourable economic outlook – if governments play an increasing role in the economies (via more defence spending, onshoring and protectionism), it’s likely to mean lower productivity resulting in slower economic growth and higher inflation. In short, lower living standards. In the US at present, it’s being fortuitously masked by the AI boom – but this could be a double-edged sword in the near term.

Second, the boost to geopolitical risk and reinforcement of populism and nationalism (notwithstanding the counter trend election outcome in Hungary) means increased uncertainty, including for businesses.

Finally, all of which runs the risk of more constrained and volatile investment returns. Which should mean that shares should be offering a higher risk premium over bonds. But at present the risk premium offered by US and Australian shares – as measured by the forward earnings yield less 10-year bond yields – remains very low.

Dr Shane Oliver – Head of Investment Strategy and Chief Economist, AMP

Introduction

Most of the time share markets are relatively calm, but periodically they tumble and generate headlines like “billions wiped off share market.” Sometimes it ends quickly and the market heads back up again. But every so often share markets keep falling for a while. Sometimes the falls are foreseeable (usually after a run of strong gains), but rarely are they forecastable (which requires a call as to timing and magnitude). And now with the US and Israel waging War on Iran its happening again with falls gathering pace as the War drags on. From their record highs earlier this year 7%, Japanese shares have fallen 12%, Eurozone shares are down 11% and Australian shares are down 9%. While the details regarding the current plunge differ from past falls, from the point of view of basic investment principles, it’s hard to say anything new. Which is why this note may sound familiar with “5 key charts for investors to keep in mind”.

The current state of the War and flow on to markets

We are now into the fourth week of the War with no clear sign of an end – despite President Trump’s frequent reassurances that the end is near.

• A problem is Trump indicated regime change was a goal – along with a group of military objectives – and killing of Iran’s leaders and musing about replicating the Venezuelan model appear to confirm this.
• So, Iran took the long-predicted response of attacking regional oil and gas infrastructure and effectively closing the Strait of Hormuz.
• Which in turn has potentially created the biggest oil & energy shock in history given 20% of world oil and gas flows through the Strait.
• This in turn has led to a surge in oil and gas prices which in turn has seen bond yields rise on inflation fears, the expected profile for official central bank interest rates rise sharply and shares fall on fears of higher inflation and rates and weaker growth and profits.
• By declaring that the War would be over “very soon” on 9 March and that he was considering “winding down” the War on 20 March, both after sharp oil price rises, Trump has signalled he can’t bear the full economic and political costs of the War. So just like his tariff TACO back down, many assume he will do the same this time which is why the rise in oil prices and fall in shares has so far been relatively mild.
• But the Iranian leadership shows no sign of waving a white flag and in fighting for survival wants to inflict maximum economic and political pain on Trump – which they know they can do by restricting oil supplies. So this makes it harder to him to do a TACO.
• There are various workarounds to the Strait blockage – Saudia Arabia’s pipeline to the Red Sea, stockpile releases, US naval escorts, Iran letting non-enemy ships through, etc – but its unclear they are enough or will work. Eg the US doesn’t have the capacity to defend every tanker. If Iran lets too many ships pass it weakens its leverage. And the US may not like the idea of Iran deciding who goes through.
• Right now, despite lots of confusing comments from Trump the risk is more escalation – with a consideration of using troops and now threatening to obliterate Iran’s power plants. Iran is threatening more retaliation against energy infrastructure in response.
• Past oil price shocks unfolded over months as the impact became clearer – 4 months in 1973 when oil prices rose four-fold & more than a year in 1979-80 when oil prices rose three-fold. It’s still early days.
• So, the threat of stagflation remains and it’s at a time of various other threats to shares around AI, private credit & stretched valuations.
• Current average capital city petrol prices in Australia of around $2.45 will if sustained add 1.5% to inflation taking it above 5% and add $114 a month to the household petrol bill which along with increasing risks of fuel shortages will lead to a big hit to economic activity.

Our base case is that the War and oil shock will be relatively short as Iran will not be able to keep the Strait closed indefinitely and Trump will look for an off ramp as political pressure builds ahead of the midterms. But it could still go on for weeks yet and so could still see oil prices rise more in the interim say to $US150. We continue to see the risk of a 15% or so correction in shares this year but the size of the threat means there is a high risk it may be deeper. Trying to work out how all this plays out is not easy. But looking at shares around major geopolitical events, the typical playout is for a sharp fall of around 8% but then a recovery over the next 12 months of around 14%. Of course, there are wide ranges around this. Given the uncertainty now is a critical time to stick to basic principles of investing. So, this note revisits 5 key charts investors should keep in mind.

Chart #1 The power of compound interest

This chart shows the value of $1 invested in various Australian assets in 1900 allowing for the reinvestment of dividends & interest along the way.

That $1 would have grown to $278 if invested in cash, to $998 if invested in bonds and to $1,000,977 if invested in shares up till now. While the average return since 1900 is only double that on shares versus bond, the huge difference between shares and bonds owes to the impact of compounding – or earning returns on top of returns over time. So, any return earned in one period is added to the original investment so that it all earns a return in the next period. And so on. Which means higher average returns over time compound into much higher end point values.

Key message: to grow wealth, we must have exposure to growth assets like shares and property that provide higher long term average returns.

Chart #2 Don’t get blown off by cyclical swings

The trouble is that shares can have lots of setbacks, eg, see the arrows on the previous chart. Even annual returns are highly volatile, but longer-term returns tend to be solid and relatively smooth. Since 1900, for Australian shares roughly two years out of ten have had negative returns but there are no negative returns over rolling 20-year periods.

Understanding that these periodic setbacks are just an inevitable part of investing is important in being able to stay the course.

Key message: big short-term swings in shares are normal but the longer the horizon, the greater the chance your investments meet their goals.

Chart #3 The rollercoaster of investor emotion

Investment markets move more than can be justified by moves in their fundamentals, because investor emotion plays a huge part. The next chart shows the roller coaster that investor emotion traces through the course of an investment cycle. Once a cyclical bull market turns into a bear market, euphoria gives way to ultimately depression at which point the asset class is under loved and undervalued and everyone who is going to sell has – and it becomes vulnerable to good (or less bad) news. This is the point of maximum opportunity for investors to buy into an asset at depressed prices. Once the cycle turns up again, depression gives way to hope and eventually euphoria. This is the point of maximum risk.

Key message: investor emotion plays a huge role in driving swings in markets. The key for investors is not to get sucked into this emotional roller coaster. Of course, this is easier said than done, so many investors end up getting wrong footed – by buying at the top when everyone is bullish and selling at the bottom when everyone is bearish (like in April last year on US tariffs, or maybe soon on worries about the oil supplies).

Chart #4 The wall of worry

There is always something for investors to worry about. And this has certainly been the case since Trump returned with his contradictory and confusing utterances. But the global economy has had plenty of worries, but it got over them with Australian shares returning 11.6% per annum since 1900, in a broad rising trend, and US shares returning 10% pa.

Key message: worries are normal around the economy and investments and sometimes they become intense – like now. But they eventually pass.

Chart #5 Timing markets is hard

With the benefit of hindsight many swings in markets around things like the GFC and the 2022 inflation surge look inevitable and so it’s natural to think about switching between say cash and shares within your super fund to anticipate market moves. But trying to time the market is difficult. A good way to demonstrate this is with a comparison of returns if an investor is fully invested in shares versus missing out on the best (or worst) days. The next chart shows that if you were fully invested in Australian shares from January 1995, you would have returned 9.4% pa.

If by trying to time the market you avoided the 10 worst days (yellow bars), you would have boosted your return to 12% pa. And if you avoided the 40 worst days, it would have been 16.5% pa! But many investors only get out after bad days & miss some of the best days. If by trying to time things you miss the 40 best days (blue bars), the return falls to 3.7% pa.

Key message: trying to time the share market is not easy. For most – whether as a super fund member or as an investor outside super – its best to stick to an appropriate well thought out long term investment strategy.

Dr Shane Oliver – Head of Investment Strategy and Chief Economist, AMP