The alarm bells should be ringing louder in markets

One of the more puzzling developments this year has been the major markets’ apparent indifference to geopolitical risk.

That’s not entirely true.

Some markets – oil, gold, crypto – have responded to particular risks. However, the equity and bond markets have ignored the threats to growth and stability of Donald Trump’s tariffs, the fiscal timebomb of the Republicans’ One Big Beautiful Bill, the Fed’s unwillingness to give investors (and Trump) the lower interest rates they have been counting on, the continuing war in Europe and, most recently, the sharp escalation in hostilities in the Middle East.

Markets remain close to record levels. Credit: AP

That may change when the US sharemarket reopens after the weekend bombing of Iran’s nuclear facilities brought the US squarely into that conflict. However, the US market remains close to its record levels and there has been only a very minor “safe haven” effect visible in the bond market.

The US dollar, rather than benefiting from capital flows towards the US, as one might expect in unsettled times, has continued to weaken and the gold price, after steadily rising this year, has fallen back slightly since Israel launched its attacks on Iran on June 12.

There’s a level of complacency within the key markets that sits uncomfortably with the developments in the Middle East, the imminence of Trump’s “Liberation Day” reciprocal tariffs and the emergence of tensions within the governing Republican Party, generated by America’s expanded involvement in the assaults on Iran and their own fiscal strategies.

Crypto, the riskiest and most volatile of risk assets, has been affected by the escalation of the conflict in the Middle East. Bitcoin was trading around $US110,000 a fortnight ago before Israel began its attacks, but briefly fell below $US100,000 over the weekend.

The most directly affected commodity, oil, has clearly reflected the rise in tensions in the Middle East. It was priced below $US70 a barrel before Israel struck, having been below $US60 a barrel in early May. It traded above $US81 a barrel over the weekend.

The surge in oil prices clearly has the potential to go much higher. So far, as appears to be the case with equities and bonds, there seems to be an assumption within the administration and among investors that America’s entry to the conflict and its bombing of Iran’s nuclear facilities represents a conclusion, at least of America’s involvement, rather than a beginning.

With Tehran saying that the bombings will trigger “everlasting consequences”, however, that would be a premature assumption.

The Strait of Hormuz is a crucial shipping lane for the global economy.Credit: Getty

Iran could respond with its own strikes on US targets in the region. It could also do what it has sometimes threatened, but never done, and close the Strait of Hormuz, the vital shipping lane from the Persian Gulf for nearly a third of the world’s oil and 20 per cent of its LNG, either by mining it or by targeting tankers.

That would send the oil price soaring above $US100 a barrel, with particular implications for China and Europe.

Where the US is energy self-sufficient, China and Europe rely on the Middle East for oil and oil-derived products. Europe, after ending its dependence on Russian gas after Russia invaded Ukraine, is now heavily dependent on LNG.

China buys about a third of the oil that transits through the Persian Gulf and is the dominant customer for Iranian oil. Israel and the US have, so far, left Iran’s oil export infrastructure, centred on its Kharg Island facility in the gulf, untouched.

An escalation in the conflict and disruption, or even a more direct threat of disruption to oil and LNG supplies, would boost inflation rates around the world. Already, the price of jet fuel has jumped nearly 50 per cent, which will eventually flow through to air fares.

Energy shocks – and developments in the Middle East could easily produce a full-blown one – have historically had very material and long-lasting effects on advanced economies and their markets, although the global economy, and the US in particular, is much less reliant on oil today than it has been in the past.

It’s also the case that a spike in the oil price would trigger a frenzy of drilling in the US – shale oil producers respond quickly to prices – which has become a net exporter of energy this decade, and would probably also see increased Russian production.

If sustained, it would also accelerate the shift away from fossil fuels towards cleaner energy sources, a safety valve that didn’t exist in the 1970s during the Arab oil embargo after the Yom Kippur War, when an Egyptian-led coalition of Arab states attacked Israel.

That embargo ignited a dramatic increase in oil prices and years of stagflation (high levels of inflation with low levels of growth) in the major developed economies.

Markets are full of risk, largely created by decisions made within the Trump White House.Credit: AP

There’s another potential source of stagflation that the major markets also appear to be discounting – Trump’s trade war on the rest of the world.

There’s already a range of tariffs in place – the 10 per cent universal baseline tariff and higher tariffs on some commodities and products – but the most threatening tariffs, the so-called “reciprocal” tariffs, won’t be unveiled until July 9.

With the average US tariff rate already multiples of what it was before Trump’s “liberation day” in April, the addition of extra country-specific rates could have a destructive impact on not just the US economy, where they would cause spikes in prices and supply shortages, but on the global economy.

In what is still, despite Trump’s efforts, a global economy, geopolitics ought to matter for investors and markets.

The equity and bond markets have so far shrugged off that threat, believing that Trump will bluff and bluster but ultimately back off. The administration’s bombing of Iran, however, may cause investors to question whether their conviction that “Trump Always Chickens Out” – the “TACO” trade – is soundly based.

There’s also the fate of the One Big Beautiful Bill that Republicans have been fighting over, a budget bill that would blow out America’s already bloated government debt and deficits. Fiscal hawks within the party have been fighting a rearguard action to try to reduce the level of spending in the bill.

The divisions within the Republicans and relationships with the White House might be exacerbated by Trump’s decision to plunge America into the fight between Israel and Iran. The isolationists within the party – and they are a significant faction – aren’t happy and are saying so, loudly.

For the share and bond markets, the uncertainties generated by the conflict in the Middle East, the looming reciprocal tariff announcements, the fate of the US budget bill, the rifts appearing within the congressional Republicans and the Federal Reserve Board’s response to all those issues ought to provide reasons for caution.

The Fed isn’t going to give the markets the rate cuts they have been pricing in until it has a firmer grasp of the impact of the developments in the Middle East on oil and, therefore, gasoline prices and a clearer understanding of the effects of Trump’s tariffs.

In what is still, despite Trump’s efforts, a global economy, geopolitics ought to matter for investors and markets.

At some point soon, it may not be just the oil market or a fringe market like crypto that reflects the risk-laden environment largely created by decisions made within the Trump White House.

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