By Nouriel Roubini
So Iran not only can afford to escalate, but it has all the incentives to do so, initially through proxies and asymmetric warfare, to avoid provoking an immediate U.S. reaction.
The assumption about what a conflict would mean for markets is equally mistaken.
Though the U.S. is less dependent on foreign oil than in the past, even a modest price spike could trigger a broader downturn or recession, as happened in 1990. While an oil-price shock would boost U.S. energy producers’ profits, the benefits would be outweighed by the costs to U.S. oil consumers (both households and firms).
Overall, U.S. private spending and growth would slow, as would growth in all of the major net-oil-importing economies, including Japan, China, India, South Korea, Turkey, and most European countries.
Finally, although central banks would not hike interest rates following an oil-price shock, nor do they have much space left to loosen monetary policies further.
According to an estimate by JP Morgan, a conflict that blocked the Strait of Hormuz for six months could drive up oil prices by 126%, to more than $150 per barrel, setting the stage for a severe global recession. And even a more limited disruption — such as a one-month blockade — could push the price up to $80 per barrel.
Oil still matters
But even these estimates do not fully capture the role that oil prices play in the global economy.
The price of oil can spike much more than a basic supply-demand model would suggest, because many oil-dependent sectors and countries will engage in precautionary stockpiling. The risk that Iran could attack oil-production facilities or disrupt major shipping routes creates a “fear premium.”
Hence, even a modest oil-price increase to $80 per barrel would lead to a sustained risk-off episode, with U.S. and global equities falling by at least 10%, in turn, hurting investor, business, and consumer confidence.
It is worth remembering that global corporate capital spending was already severely dampened last year, owing to worries about an escalation in the U.S.-China trade and technology war, and the possibility of a “hard” Brexit.
Just as these risks — that is, the “option value of waiting” — were receding, a new one has emerged. Leaving aside the direct negative impact of higher energy prices, fears of an escalating U.S.-Iran conflict could lead to more precautionary household saving and lower capital spending by firms, further weakening demand and growth.
Moreover, even before that risk emerged, some analysts (including me) warned that growth this year might be as tepid as growth in 2019.
Markets and investors had been looking forward to a period of easier monetary policies and an end to the tail risks associated with the trade war and Brexit. Many market watchers were hoping that the synchronized global slowdown of 2019 (when growth fell to 3%, compared to 3.8% in 2017) would end, with growth approaching 3.4% this year.
But this outlook ignored many remaining fragilities.
Now, despite Wall Street’s optimism, even a mild resumption of U.S.-Iran tensions could push global growth below the mediocre level of 2019. A more severe conflict that falls short of war could increase oil prices to well above $80 per barrel, possibly pushing equities into bear territory (a decrease of 20%) and leading to a global growth stall.
Finally, a full-scale war could drive the price of oil above $150 per barrel, ushering in a severe global recession and a fall of over 30% for equities markets.
While the probability of a full-scale war remains low for now (no more than 20%, in my view), the chances of simply returning to the pre-assassination status quo are even lower (say, 5%).
The most likely scenario is that the situation escalates into a new grey area (indirect conflict and direct clashes falling short of war) that would drive up the risk of a full-scale war.
At that new baseline, the market’s current complacency will look not just naive, but utterly delusional. The risk of a growth stall or even a global recession is now much higher and rising.