Why The Iran War Could Reignite Inflation

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1:41Mark Zandi:Today's number 10. That is the percentage of U.S.-imposed regime changes that have ever led to a successful and lasting democracy. The other 90 % have actually made things worse, resulting in harsher governance and, in many cases, civil war. But I'm sure that this time will be different. Money market matters. If money is evil, then that building is hell. The show goes on! The folks are never watched the show, show! Welcome to Prof G Markets. I'm Ed Elson. It is March 4th. Let's check in on yesterday's market vitals. The major indices all dropped in early trading as much as 2.5 % before pairing losses.

2:26Mark Zandi:Still, they ended the day firmly in the red. Meanwhile, Treasury yields spiked again, and the price of oil rose as much as 9 % before pulling back on those gains. Okay, what's happening? As war with Iran escalates, so do investors' anxieties. The major indices sold off yesterday morning as the U.S. warned that its strikes on Iran will continue to ramp up in force. Brent crude, the international benchmark, briefly hit$85 a barrel for the first time since 2024. Then President Trump said the U.S. will escort and provide insurance for oil tankers moving through the Strait of Homoz. The indices recovered some of their losses on that news, and crude retreated from its highs.

3:09Mark Zandi:Still, oil prices are up 13 % over the past week. In the bond markets, the 10-year treasury yield moved higher on fears that higher energy prices could boost inflation in the US. Meanwhile, the risk off trade spread overseas, with European stocks falling 3%, and Asian markets slipping. South Korea's Kospi plunged over 7%. Investors rushed to safe haven currencies. The dollar rose to its highest level since January, and the Swiss franc hit a 10-year high against the euro. Tons of stuff in here, tons to unpack. And so we're going to do something different today. Instead of going to one guest, we are going to go to three guests.

3:46Mark Zandi:We've got our panel of experts here. Today we're speaking with Mark Zandy, Chief Economist at Moody's Analytics, who you know, Robert Armstrong, U.S. Financial Commentator for the Financial Times, and Matthew Martin, Semaphore's Saudi Arabia Bureau Chief. Mark, Rob, Matthew, thank you very much for joining me on the show. So, Rob, I'm going to start with you. We've seen some interesting reactions here from the markets. Specifically, it seemed that people weren't that worried on Monday, and then on Tuesday, maybe more worried because suddenly stocks sold off. What do you make of how the markets have reacted so far?

4:25Robert Armstrong:It seemed pretty clear on Monday morning that the market was pricing in a short, tidy little war. Something on the style of Venezuela, regime change light, where you strike or kidnap or whatever, and it all ends fairly briskly. I think the market is still pricing in some of that, but as Iranian resistance has proved a bit more resilient than expected, that has to show up in things like crude prices and by extension inflation expectations. That in turn means that stock prices are creeping down. Again, nothing like the worst case scenario is being priced in right now, Ed. Right. But a slightly worse best case scenario is what I would say is priced in now.

5:19Mark Zandi:Matthew, you're the only one of us who's actually in or around the region right now. What are you seeing in the Gulf? And does Rob's view of what investors are pricing in make sense to you?

5:34Matthew Martin:Yeah, look, I think it does. I mean, I've been, look, I'm based in Riyadh today. day. I've been out and about in the city. Generally, people are still going about business. Went out to dinner with some people this evening. Obviously, the war is a topic of conversation, but it's not the only topic of conversation. People are still continuing to talk about other things. I think that is kind of reflective in what you're seeing in markets. It is a factor, but it's not the number one thing that people are thinking about. Also, within the region, I think people are taking this very, very differently as well.

6:10Matthew Martin:I mean, if you look in Dubai, you know, there are some people who have been in buildings which have been struck by Iranian drones who never expected that they would live through something like that and are panicking about it and are wanting to leave. And depending on, you know, you could live in other parts of the city and have no idea of what's going on and be pretty isolated from it as well. So, you know, I think that sort of goes into this kind of psychology of how people are responding to it. You know, some people are thinking this is going to be really significant. that this is going to be dramatic and long-lasting, and some people are kind of taking a much more sanguine view of it.

6:42Mark Zandi:Mark, it sounds like people are worried about this, but not maybe as worried as we would have thought a week ago, a month ago, if you told us what the headline actually is. What do you make of investor reactions?

6:57Ed Elson:I mean, I think the description that Rob gave is dead on. I mean, I think people are still, investors are still expecting this thing to blow over pretty quickly. Maybe it's not going to be in a day or two like Venezuela, but more like a week or two. So if that's the case, then$10 on a barrel of oil, you know, a couple of three percentage points off stock prices, bond yields up a little bit, you know, that kind of is consistent with that perspective. And I think that's kind of my sense of things. I mean, that would be my kind of baseline view down the middle of the distribution of possible outcomes.

7:27Ed Elson:Now, the distribution is is why there's a lot of ways this can go. And if this does drag on beyond a week or two into, you know, a month or two, then then we're talking about, you know, different kind of scenario. And I think the market reaction would be much more severe. But right now, I think, you know, people are a little disappointed. Maybe this was going to be Venezuela, but it didn't turn out to be that way. But I still think people are holding on to a week or two. So in that context, this kind of market action is pretty close to what you would expect.

7:57Robert Armstrong:One thing, Ed, if I may, just to follow up on that, is what I would have your listeners be alert to, if things do get worse, is the relationship between stocks and bonds, which is really interesting here. If you get positive correlation between the two, that's bad, right? One of the things we like to happen in our portfolios is that when the stocks go down, the bonds go up and vice versa. but an oil price shock like you might get if the Strait of Hormuz is stuck closed for a while is inflationary. So the bonds can't go up when your stocks go down, right? And so it's been interesting that they've been going down together and that's a painful scenario.

8:41Robert Armstrong:That's stagflationary and that's kind of the pain point to watch, I think. I don't have any predictions. I don't know anything about wars. I don't have any predictions for what's going to happen, but that's the thing that kind of worries you about this particular flavor of conflict.

8:58Mark Zandi:Yeah, Mark, there are pretty significant implications, it seems, for consumers here, and that is we put oil in our cars and most of the oil is coming out of this region. What actually is the relationship between what is happening in Iran right now and how that would impact our lives and prices at home.

9:24Ed Elson:Well, I'll give you some rules of thumb. So if oil prices are up, stay up$10 a barrel. So on WTI, West Texas Intermediate, which is the key price in the U.S., was$65 a barrel before all this. Now we're$75 a barrel. I'm rounding, obviously, but say it's$10. That would, if it's sustained for two, three, four weeks, will sustain an increase in the cost of regular unleaded by about 25 cents. So right now, the U.S. consumer nationwide is paying about$3 for a gallon of regular unleaded. It'd be$3.25. You know, that's manageable, but a bit uncomfortable, particularly in the context of all the affordability concerns that Americans are facing right now.

10:07Ed Elson:Everything else is up in price. The only thing that wasn't was the cost of a gallon of regular unleaded. And now it's also headed up. And of course, if it's going from$3 to$3.25, the next question is, well, is it going to go to$3.50,$3.75? And then that's real money. So, you know, it's moving in the wrong direction. It's going to make already very anxious Americans even more anxious. And in this case, the other pernicious aspect of it is, you know, a higher gas price doesn't matter at all for a high income, high net worth household. They don't really, you know, it doesn't matter if they're paying a quarter more for a gallon of regular unleaded.

10:40Ed Elson:But it means a lot for lower middle income Americans. I mean, that's real money. If you add it up over a year, it's two, three hundred bucks in addition, you know, 20 bucks a month. And that's pretty tough for people that are in that kind of situation. So there's a lot of aspects of this from the prism of the American consumer that make it more uncomfortable than it typically would be just because of where we are on this affordability issue.

11:02Mark Zandi:Stay tuned for more of this panel right after the break. And for even more markets insights, you can subscribe to my weekly newsletter, Simply Put, at edwardelson.substack.com.

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12:24Robert Armstrong:Support for the show comes from Morgan Stanley's Thoughts on the Market. Today's financial markets move fast. Morgan Stanley moves faster with their daily podcast, Thoughts on the Market. Thoughts on the Market covers daily trends across the global investment landscape with actionable insights from Morgan Stanley's leading economists and strategists. And with most episodes under five minutes long, staying informed has never been easier. Listen and subscribe to Thoughts on the Market wherever you get your podcasts.

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13:27Mark Zandi:We're back with our panel. So, Matthew, when I look at the international markets, Korea's market down, Germany's DAX is also down, FTSE in the UK aren't on track for its worst day in almost a year. What is kind of interesting here is that it seems that the concerns are more exacerbated outside of the US, perhaps because of proximity to the region, perhaps because of what that will do to energy. I mean, why is that? How do we account for the difference here?

14:02Matthew Martin:Well, I think probably a big part of that is going to be the impact of gas prices in particular. Because, you know, we've seen the attacks on the Qatar energy facilities and the shutdowns that they've had. I mean, that's led to huge increases in the gas price, which is obviously that's a big part of the feedstock that's going into Europe and is going into Asia as well. and Qatar has become a huge producer of gas. So that's going to feed immediately into a big inflation problem for a lot of those economies. So I think that's really what is at the root of the way that those markets are digesting this.

14:38Robert Armstrong:Yeah, the difference between Henry Hub gas here in the United States and European natural gas is striking. You know, our natural gas is up 6-7 % or something like that. Mark may know better than me. European gas is up like 40%. And especially Germany is an extremely gas-sensitive economy.

14:54Ed Elson:You know, the other thing, Ed, is that the U.S. produces a lot of oil, right? I mean, at the end of the day, the U.S. produces as much oil as it consumes. So consumers get nailed, but producers benefit, not immediately, but over time if prices remain high and persist. But in many of those other countries, they're full-on consumers. They don't produce any energy, so there's nothing but negative here. So you have these differentials across the globe because of the fact that the U.S. is now the largest oil producer on the planet.

15:23Mark Zandi:Right. Which brings up questions of how insulated from all of this actually are we? And perhaps we are quite insulated, but it's kind of an interesting dynamic because it was us who launched the attack in the first place. So does that essentially mean that we can kind of do what we want over there in Iran and we aren't particularly affected? I mean, let's look at like liquid natural gas, for example. What kinds of effects, Mark, would an increase in LNG prices over in Europe, would that have much of an effect on the US? Would that be a problem? Is that part of the calculus for people in the administration right now?

16:08Ed Elson:Well, I think that's second order, third order. I mean, don't get me wrong. I mean, I think the effects most immediately and most significantly are negative for the U.S. There's no doubt about it. consumers, American consumers, low-middle-income households, the folks that vote, they're going to feel this right away, and it's going to affect them, you know, in a significant way. Over time, the higher oil prices might lift investment and production in the oil patch and offset some of the negatives. But this is still, you know, soundly negative. But the fact that natural gas prices are rising in Europe, you know, has effects on Europe, obviously, and then that reverberates around the world in the form of weaker economic growth.

16:50Ed Elson:But that's, I view that to be more second, third order, as opposed to, you know, the initial things that we should be worried about.

16:56Robert Armstrong:I don't think we have enough export infrastructure to really make hay off Europe's price problems. We'd like to have more export terminals and so forth. We just don't have them. I mean, I think the point of connection to U.S. markets for U.S. investors and how we feel it, it's going to be the Federal Reserve. So last week we got two unpleasant inflation prints in the form of producer prices, prices paid was high, and then we had the ISM manufacturing report and their prices paid reading was bad. And so already you can sort of see the Federal Open Market Committee thinking, geez, maybe these were cutting rates might not not be so smart.

17:42Robert Armstrong:And then you get another inflationary element into the picture, which is gas prices going up, which feed into food prices and have a big effect on sentiment, you know, inflation expectations. Maybe those rate cuts come off the table. And, you know, it's a horrible thing when there is something as serious and mortal and morally important as a war going on. And you're sitting here talking about what a bunch of nerds in Washington are going to do with interest rates, but, you know, this is what they pay me to do. I'm not saying this is the most, I would never say this is the most important thing about what is going on right now, but the fact is where U.S.

18:19Robert Armstrong:investors are going to feel it might be through rate policy. Right.

18:23Ed Elson:You know, the other thing, Ed, you might think, the way to think about it is, you know, the U.S. economy has been hit by three negative supply shocks in the last year, first being the tariffs, right? That's inflationary and weakens growth. Then it's the immigration policy, heavy-handed immigration policy, that raises costs and reduces growth. And now you've got these higher oil prices. So the U.S. economy has been pretty resilient, you know, kind of managing through those other shocks. But you've got to ask yourself the question, you know, at what point does this all kind of feed on itself and become, you know, too difficult to digest?