“We Could Be Looking At A War Economy That Nobody Today Has Ever Experienced Before”

By Benjamin Picton, Senior Macro Strategist at Rabobank

It Never Rains, But It Pours

Brent crude futures closed up more than 5% on Friday, peeking back above U$90/bbl for the first time in almost a fortnight. US 10y yields were down more than 8bps at 4.61% and the long bond was down more than 10bps to 4.75%. That equates to a loss of 19bp for the 10y, and 21bps for 30y treasuries in just one week. Even equities appear to have gotten the risk-off message late in the week. The S&P500 closed down 22 points with losses being led by the high beta information technology sector and consumer discretionary, while defensives and energy performed well.

Who can blame markets for being jittery. The events of the last week are shocking, if not entirely surprising. The world now holds its breath as Israel prepares for a full-scale ground invasion of Gaza, with only unseasonal torrential rain delaying the seemingly inevitable.

As the title of today’s Daily suggest, it never rains, but it pours. US Secretary of State Anthony Blinken now finds himself the busiest man in the Biden administration as he jets around to be chastised like a naughty boy by world leaders in the global south. The war in Gaza is poised to spread and open new fronts. Iran has warned Israel that this may occur if Israel invades Gaza (as appears likely), while the US has in-turn told Iran to stay out if it knows what’s good for it. There have already been exchanges of fire between Israel and Iranian proxy Hezbollah over Israel’s Northern border with Lebanon, and recently there has been news of rocket attacks from Syria hitting Israeli positions in the Golan Heights.

Blinken has warned in recent days that Azerbaijan could soon invade Armenia, and some analysts have pointed out that the United States’ military preoccupations, along with the absence of monsoonal rains in October, presents China with a window of opportunity to attack Taiwan. Meanwhile, the second US carrier group deployed to the Eastern Mediterranean has been temporarily delayed to ensure that the flagship USS Eisenhower is in “peak readiness”. Two carrier strike groups armed to the teeth is an act of gunboat diplomacy with a clear message for Iran: “don’t try it”.

We have been suggesting for some time that the world security order is collapsing. Practitioners of idealist foreign policy will have to update their favourite bromides of the “rules based order”, because such a system no longer exists (if it ever did). Recent events suggest that we are back to the Hobbesian order that prevailed before the long peace, and potentially on a path to something worse than Great Power tension and regional proxy wars.

As popular historian Niall Ferguson alarmingly describes in The Times over the weekend, “a cascade of conflict… has the potential to escalate to a Third World War.” That is a worst case scenario, and one that we can still avoid, but it is a risk. With events moving as fast as they are, nobody can anticipate what might light the fuse on the geopolitical powder-keg. The Kaiser certainly never anticipated the actions of Gavrilo Princip in 1914.

Indeed, US national security advisor Jake Sullivan’s now infamous statement just two weeks ago that “the Middle East region is quieter today than it has been in two decades…” is starting to look a bit like Neville Chamberlain walking off a plane declaring “peace in our time!”

What are the implications for financial markets of this worst case scenario? Well, that’s not really the right question, but if we have to answer it it’s probably a combination of inflation, financial repression, scarcity and a long-overdue reversal of multiple expansion. We would be looking at a war economy that nobody in the markets today has ever experienced before.

Unthinkable as that prospect is, it’s not hyperbole. The tails are getting fatter by the day and this week at least, a clearing of the clouds will herald the beginning of the storm, rather than the end.