Ep. 215 - Economic impact of armed conflicts

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According to our strategic report on key themes for 2024, the prolongation of existing and emergence of new armed conflicts will likely remain a major source of geopolitical instability in the world economy. Following Iran's recent strike on Israel GPE, we posed the question, what could an escalation mean for the global economy?I'm Kristen Hallam, lead content strategists for global intelligence and analytics at S&P Global Market Intelligence ORG, and your host for this episode of the Economics and Country Risk ORG podcast. Joining me for this discussion is my colleague from Market Intelligence, Ken Watrette, Vice President, Global Economics ORG. Ken, welcome back to the podcast podcast and thank you for being here. Hi, Kristen PERSON. Great to be here. Thank you for inviting me.

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It was a pleasure to have you on. Ken, have we made any adjustments to our economic forecast to reflect

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these recent events in the Middle East LOC and the potential for further escalation? We have been

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making some adjustments here and there to reflect various recent developments, including the shift in expectations for US GPE policy rates and its knock-on effects. But for a few reasons, we haven't made radical changes to our forecastsfollowing the missile strikes in Israel and Iran GPE. First and foremost, we need to take a little time to assess how the situation in the Middle East LOC will evolve from here. And also the base case from our geopolitical experts is that a region-wide conflict will probably still be averted. And consistent with that, we've had so far a very muted reaction to the news from commodity prices and financial markets.I mean, if we look at the price of Brent crude, for example, it's actually declined to a little below $90 a barrel. And it could be argued that an increased risk of escalation had already been priced in with oil prices gradually rising through most of the year so far.

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And what is our current base case for the economy?

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Well, we've actually been revising up our growth forecasts for this year in quite a few countries over the last few months. Our global growth forecast, for example, has risen from 2.3% back in January to 2.6% in the latest update. And it incorporates a gradual pickup in momentum, quarter over quarter growth rates this year are actually forecast to be higher than in the second half of last year. So that requires some explanation given the increase in uncertainty that we've seen. Now in part it reflects the recent resilience of the US economy. It also reflects our expectations for a pickup in Europe LOC, albeit a ratherinsipid one. And also we see continued strengthening some outperforming economies, including India GPE. And it's also important to flag that our PMIs, our purchasing managers indices, they've been telling us for several months now that the global growth momentum is actually improving and it's becoming more broad-based. So if we look at the global composite PMI output index, which is a bellwether for global growth, it's improved in each of the five months to March,and the flash data that we've just had released for April suggests that the pickup was broadly maintained, despite the missile attacks that we've seen and related risks. Now, this all being said, we do need to keep a bit of perspective because the forecast of 2.6% global real GDP growth this year is nothing to shout about. And actually, the peak quarter over quarter growth rate in our profile is well belowthose that we've seen in prior economic cycles. So the direction of travel is upwards, but there are still various headwinds expected to hold economic growth back. Got it. So positive trajectory,

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but nothing to get too excited about yet. And, you know, as you suggested earlier, I imagine it's really challenging to incorporate geopolitical shocks into our economic analyses. But I also imagine that we've had quite a bit of practice in the last few years at doing that. How do we approach that in a way that doesn't result in volatile swings in our

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forecast? Well, as you say, it can be very challenging. You know, we clearly want to avoid huge swings back and forth in our economic forecasts. But at the same time, we also want to avoid an excessive inertia where, you know, the forecasts are not reflecting emerging developments and our expectation of how things will evolve in the future. Now, one advantage we have is that most of our forecasts are run through a global macroeconomic model. That's called the Global Link Model or GLM.So we can actually run alternative scenarios to try to calibrate the economic effects of various shocks. And we have in the past looked, for example, at spikes in oil prices, changes in inflation conditions, changes in monetary policy conditions, and a wide range of other different shocks. And we can pull levers in the model to try and calibrate the effects. So we don't necessarily have to change the base case. You know, if this is a tail risk event, which is low probability, but high impact, we can use the GLM to try and ascertain what the

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economic implications of that shock would be. You mentioned the oil price shocks there, and I imagine that would be one of the key transmission channels if there were to be an escalation of the conflict in the Middle East LOC. What would be other transmission channels that we might expect to see?

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Yeah, that's a really important point. And I think in this particular issue, there are various transmission channels to consider, and that means it could be a multifaceted economic shock with significant adverse effects. So the obvious one, as mentioned, is higher energy prices, particularly crude oil prices, given the importance of the region for global oil supply. But then there's lots of other channels. Think about financial conditions. They could become much less favorable, you know, be that via higher short or long-term interest ratesthan otherwise, or tighter credit conditions from financial institutions or more volatile financial market conditions in general. Then we have trade and supply chain disruptions. Trading routes would be affected by a broader conflict. Then there's negative confidence effects. And that would likely be aggravated by declines in asset prices.You know, should interest rates end up remaining higher for longer and uncertainty persist. So there are lots of different channels for how a shock like this could impact on economic activity and we can pull those levers in our global link model to try and again gauge what the economic implications would be.

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And what would the implications for our forecasts be if we saw some of these transmission channels that you mentioned like tighter credit

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conditions and so on? Well, I think it's probably easiest to think of this as a series of impact, you know, a bit like a chain reaction. So higher oil prices would mean higher consumer price inflation that squeezes household real incomes and and hits consumer spending. And with labor market still generally tight, central bank fears of second rounds on, second round effects on inflation via stubbornly high wage growth.Those concerns would limit the scope for interest rate cuts and in some cases might necessitate additional monetary policy tightening. We typically see in a period of high uncertainty, US GPE dollar appreciation, that would actually intensify those inflationary worries because the currency weakness elsewhere would not only aggravatethe increase in oil prices, but it would raise import prices more generally. And then against the backdrop of less favourable financial conditions, equity prices would probably fall sharply from their current elevated levels. That means negative wealth effects. We could consumer confidence, further damaging consumption prospects, and related to that uncertainty over future demand, and again, less favorable financial conditions, hold back corporate investment, and so on. So the bottom line is a very unfavorable combination of circumstances and economicgrowth prospects becoming much, much weaker than in our base case. You know, there are variations, of course, in the impacts depending on the breadth of the conflict and in turn the duration and scale of the effects on oil prices, confidence, financial conditions and so on. But clearly that would be a material change in economic growth prospects

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for the worse. Lots to keep an eye on there for sure. And Ken, what types of economies would be hit hardest by an escalation?

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Yeah, that's also a really important point because given these various transmission channels, we've been talking about the aggregate effects on global economic activity we think would be substantial, but they wouldn't be evenly spread. And probably the area to focus on there is to think about whether an economy is a net energy importer or a net energy exporter. You know, the net energy importers would be hardest hit, particularly those most relianton oil supplies from the Middle East LOC, and that includes many of the larger economies in Europe and Asia Pacific LOC. But if you're a net energy exporter and you're not located in the region that's being hit by the conflict and the disruption, then, you know, your economy will be less adversely affected. And that includes these days the US GPE economy, which now has net energy exporter status. Now, there are some caveats to that because the US GPE household sectortends to be more sensitive to negative wealth effects related to declines in equity prices. And also, the Federal Reserve sounds more worried about inflation in the US GPE than some other major central banks. So probably in the US GPE case, the argument for tight for longer financial conditions is particularly appropriate. But for other energy exporters who are not in the Middle East LOC, they get the potential benefit of higher prices and no disruption to supply. So we need to think about those differences across countriesand regions depending on their structure when we think about the fallout from a scenario like this.

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Yeah, with so many different transmission channels, it's hard to imagine that any economy would remain untouched in the event of an escalation.

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Yeah, I think we need to think about the direct and the indirect effects of this, and we've touched on many of these already. You know, if you're thinking about the energy implications, then some economies might benefit, but if you're thinking about the broader implications and, you know, we're talking about potentially a rather significant hit to global demand then of course even if you're not directly affected by the conflict and it can have an impact on your ability to grow the economy through the export channel for example and thesedifferences are really quite important you know some economies don't have much effect through the wealth channel consumer spending is not particularly sensitive to changes in asset prices. Others are very sensitive. So these differences in structure and differences in transmission channels are really important. So earlier I mentioned that we had some experience

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with incorporating geopolitical shocks and I was thinking about the Russia GPE-Ukraine war. How does that conflict compare to, you know, what we could potentially see within escalation in the Middle East LOC? Well, there are some obvious parallels, including

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disruptions to energy supply related to that higher energy costs, higher inflation, an impact on monetary policy conditions globally, increased uncertainty, more volatility in financial markets and so on. But I think with the Russia-Ukraine conflict, it was very much concentrated on Europe LOC, particularly manufacturing-sensitive areas like Germany GPE, where we've really seen economic conditions remaining very weak for quite a long time. Many economies in Europe had become very heavily dependent on cheap energy supplies from Russia GPE,so the effects were particularly pronounced there. A crisis in the Middle East LOC would have much broader effects on the global economy, including to many economies around the world, which have become very dependent on oil supply from that region. And as mentioned, you know, this includes many in Asia Pacific, which were comparatively unscathed by the after effects of the war in Ukraine GPE,but which are highly dependent on oil supplies from the Middle East LOC. So I think we should think of this as a much more global shock. It doesn't mean that Russia, Ukraine GPE didn't have implications more broadly, but I think given the importance of oil supply for different regions in the Middle East LOC, this has the potential to have

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much more wide-ranging effects. Yeah, some good points there. So what indicators should we be keeping an eye on as the situation in the Middle East develops, Ken? Well, there are some obvious

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ones, which we've mentioned already. I mean, look no further than the evolution of crude oil prices, for example. And then there are things that we would also see some effects coming through quite quickly. Think about various measures of financial stress. I mean, we did see some metrics of financial market volatility pick up markedly in mid-April, when the tension startedto escalate, including the VIX index, a measure of volatility in equity markets. And there are other things that we would typically look at inflows into safe haven currencies like the Swiss francs or safe haven assets like US GPE treasuries, for example. And that's quite interesting also because so far we've seen a very muted impact on the US Treasury market. Yields are still close to their highs for the year, and yields are up by about 80 basis points year to date. So it looks like the focus for the US treasury market still is very much firm recent US GPE inflation data and the reduced scope for Fedrate cuts rather than the potential risk of escalation in the Middle East LOC. Now, of course, that could change and could change very quickly, but these are the kind of indicators that we would typically keep a close eye on. As for the economic effects, we'll see any impact in our own PMI data much more quickly than an official data. The flash PMI figures are published before the end of each month. So they're giving us a real-time gauge of what's happening across a wide range of areas, you know, be it output, orders, prices, delivery times, and so on. So in termsof reflecting the economic effects quickly, we'd be keeping it very close on the PMI data. All right. We'll have our PMI economists on the podcast in a few weeks quickly, we'd be keeping it very close on the PMI data. All right.

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We'll have our PMI economists on the podcast in a few weeks, so I'll be sure to ask them about that. So, Ken, it's time to wrap up our discussion. Any final thoughts for our listeners?

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Well, we live in more uncertain times, the days of low and stable inflation, the days of low and stable inflation, low and stable interest rates, and generally favorable and predictable economic conditions feel like a rather long time ago. Still, drawing on the wide range of experts across our business, we can help our clients to navigate a path through

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these much more uncertain times. Well, thank you for that, Ken. I really appreciate you joining us on the podcast again to share your insights on the global economy. And thanks to you, our listeners, for tuning in. Please join us next week to learn more about the forces creating risks and opportunities for businesses in 2024. Thank you for listening to the Economics and Country Risk ORG podcast.

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