Podcast
Paul Diggle
Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn.
Luke Bartholomew
And I'm Luke Bartholomew, Senior Economist at abrdn.
Paul Diggle
And today we are talking about the geopolitical, macroeconomic and market consequences of the conflict between Israel and Hamas taking place in the Gaza Strip. Now, these events are first and foremost human and humanitarian tragedies. They're very sensitive topics. And of course, the potential economic and asset market implications are very much secondary considerations. But as economists and investors, we do have to think about possible geo-military scenarios, possible escalation paths, and what all this means for energy markets and for the global economy. So that is what we're going to try to do this episode and we're joined in that endeavour by Lizzie Galbraith, political economist at abrdn. Welcome, Lizzy.
Lizzy Galbraith
Hi, Paul. Thanks for having me.
Paul Diggle
So let's start Llizzy with the geo-military scenario analysis. We've sketched out four possible paths for how the conflict could go. What's our base case?
Lizzy Galbraith
So in our base case, we expected that Israel, as it has done, would conduct a ground operation into Gaza. But crucially, we also anticipate that the conflict does not escalate into the wider region in this base case. So yes, we anticipate that some other regional actors do contribute in some way, that we do see some escalation of violence in the region, but crucially, that that does not spill over into wider conflict and open up formal second or multiple fronts in this conflict. We do also anticipate in this scenario that there are some protest movements across the wider region. And we do anticipate that after the end of this conflict, that we do not see any wider regional deterioration in political stability.
Paul Diggle
And what sort of probability would we give to that base case, Lizzy?
Lizzy Galbraith
So we're currently assigning that a 50% probability. So we think it's quite likely on balance of probability that we remain in this base case, principally owing to the deterrence effects that, particularly Israel and the US are focused on that seem to be containing the risk of wider conflict at this stage.
Paul Diggle
But nonetheless, there are escalatory scenarios. These are the scenarios that the market tends to worry more about. What's the main path to escalation?
Lizzy Galbraith
So we've estimated that this is probably about a 40% probability. But in this main escalatory scenario, we see the conflict broaden out to include other Iranian-backed actors in the region. The particular risk here would be Hezbollah, which is the largest of these groups. And essentially, we see them intervene directly into the conflict to try and distract Israeli attention wholly from Gaza. And in that scenario, we see a much more direct intervention from multiple actors potentially, and international conflict, mediation and deterrence efforts largely fail to prevent this this conflict from broadening out. That means that Israel will have to act on multiple fronts, it also is likely to cause a deterioration in the humanitarian situation more broadly across the region.
Paul Diggle
And then we have sketched out a third most severe kind of tail risk escalation, a much larger, full scale Middle East conflict or war, in particular, involving Iran directly. What are the considerations about that - around that severe escalatory scenario?
Lizzy Galbraith
So we don't think this is a particularly likely scenario. But we did want to sketch out what the worst-case scenario would look like. And in this scenario, we think that the most likely way you'd see something like this happening is that credible evidence would emerge of Hamas’s close allies in the region having direct involvement in the planning or facilitation of its attack on Israel. And that leads to a substantial military response from Israel itself, that these actors then respond to, and crucially, the key actor in this would be Iran. If you had evidence, direct evidence that Iran had been involved in the original attack, and Israel conducted strikes on Iran in response to that evidence, you're at much higher risk of wider deterioration in regional stability, more actors becoming involved and the conflict deteriorating quite rapidly. We've only attributed a 5% probability to this scenario as we think it is incredibly unlikely to occur. But nonetheless, we think this is how the worst-case scenario would come about, given where we are right now.
Paul Diggle
And then the fourth scenario that we sketched out, and I should say that we did this work shortly after the original attacks but before the ground invasion, was a de-escalatory scenario, in many ways. That scenario’s been and gone now. But there are, of course, still ongoing discussions Lizzy about the possibility of temporary cessation in hostilities and so what are the considerations around that de-escalatory path?
Lizzy Galbraith
Yeah, so the de-escalatory path essentially involves diplomatic efforts led by the US and Qatar effectively causing Israel to pull back from its offensive in exchange for the release of hostages and allowing humanitarian aid to enter Gaza. We again assigned this a 5% probability when we did the original work, and it continues to look quite unlikely that this is going to occur, although there is growing international pressure for a temporary cessation of the operation, or even a ceasefire. We've not seen any evidence that Israel is interested in doing so at this stage.
Luke Bartholomew
Now, as you say, Paul, the global macro consequences of this conflict are very much second order in the grand scheme of things. But in terms of the way in which this would have global macro consequences, I think there are probably two main transmission channels The first is through something like a geopolitical risk premium that attaches to assets in the presence of uncertainty, somewhat like the term premium that we were talking about in a previous episode, that's compensation to investors for uncertainty. And so far that measure, at least which can be proxied, by things like geopolitical risk uncertainty, policy uncertainty indices have picked up but haven't really spiked. So that doesn't seem to be a particularly large channel so far. And then the second is, of course, via commodity markets and oil, in particular. And of course, there was this spike in energy prices immediately following the attacks. But actually, since then, that reaction has largely faded as well. And as we speak today,
oil prices are actually lower than they were on October the seventh. But in terms of how it might affect energy prices, I guess there are a couple of direct effects. First, is the loss of Israeli gas field supply through this conflict, so just less gas supply coming to the market. Second, I think there'd been some expectation that had the Israel and Saudi talks that had been ongoing before the attacks - had those been successful and led to sort of more normalised relations between the two countries, then that would be accompanied by an increase in oil supply from the Saudis. And obviously, those talks have now broken down. And so the possibility that their successful conclusion would lead to higher oil supply has faded. And therefore, there's this sense that there won't be as much oil in the future to supply to the market as they might otherwise have been. And thirdly, in the very tight oil markets that we saw over this summer, I think there had been a sense that some Iranian supply had been leaking onto oil, getting past sanctions and getting onto the market that way. And there was this anticipation that maybe as a consequence of the escalation in issues in the Middle East that those sanctions would then be policed more heavily, and that supply would be curtailed somewhat. But beyond those sorts of effects, I guess there's also the fact that what markets price is risk distributions. And it's just the possibility of some of these escalatory scenarios that Lizzie was talking about that could push up energy prices as well.
Paul Diggle
Yeah, indeed, I think it is the severe escalation side, the 5%, full-scale Middle Eastern war scenario, which is where the most serious energy price consequences would occur. So thinking about this tail-risk scenario, it would likely affect the flow of oil through the Strait of Hormuz, this narrow band of water at the south of the Persian Gulf through which around 20% of global oil supply flows. Perhaps a third of global LNG supply would be at risk in that narrow strip of water, which is of course just off the south coast of Iran.So you'd likely see a sharp hit to global oil and LNG supply. And I think it's possible, again in this tail risk for all prices to approach, the real terms highs of some past oil price shocks, which, after all, have also been driven often by a war in the Middle East. So a peak above $140 a barrel, for example, is a plausible worst case that we kind of want to think about and model. Now, a couple of important questions follow from that, for example, what would the rest of OPEC do during a large oil price shock? History is important here. So in 1973, during the Yom Kippur War, a lot of Gulf states or OPEC as a whole, then embargoed oil supply to Israel's international allies. That drove then what became a decade of very high inflation, initially being triggered by this oil price shock. That parallel probably wouldn't hold today. Saudi would potentially increase oil supply in the event of a very large upward shock on prices, there would also be potential recessionary consequences of a large oil price shock. Indeed, big upward shifts in the oil price are often one of the ingredients into global downturns. And that would ultimately reduce oil demand and therefore price. So it could be that a large upward shock to oil prices can necessarily be temporary and self-defeating but nonetheless, we'd have some important growth and inflation consequences along the way. And indeed, there are rough and ready rules of thumb that help you think about the effect of higher oil prices on growth and inflation, the roughly 50% move that's plausible, in this tail risk downside scenario could potentially knock about 1% off GDP for oil-importing nations. Remember that the US is now a net oil exporter. But obviously, many economies are net importers and would see quite large negative GDP shocks in that sort of scenario. And meanwhile, a move of this magnitude adds perhaps 2% to headline inflation in a lot of economies. So quite meaningful, global macro consequences in this downside scenario.
Luke Bartholomew
And in terms of how central banks would think about those growth and inflation consequences. Because obviously, this is a bit of a trade-off inducing shock for a central bank in the sense that these negative supply shocks push growth and inflation in different directions. It's much easier for a central bank to deal with demand shocks that push growth and inflation in the same direction. Whereas this one, some of their objectives can be in different directions, or the forces are pushing in different directions. And so there's a trade-off. And typically, the way in which central banks have dealt with this, at least over the last 30-40 years or so, is to quote-unquote, look through the impact on inflation.
Just take it as a one-off hit to the price level that automatically sort of washes out of the inflation calculation in time. And the reason for that is, one, that they might not just have the tools to be able to deal with the inflationary consequences, of an energy price shock in the short term. Monetary policy famously works with long and variable lags. So by the time the impact of the monetary policy has come through the commodity price shock was likely been gone. And perhaps it already just washed out at the inflation calculation. And indeed, there was some quite famous research done by Ben Bernanke, who was formerly Chairman of the Federal Reserve back in his academic career showing that a large part of the negative economic effect that you got from energy price shocks was actually partly caused by how central banks ended up tightening into that and exacerbating the economic pain. So yeah, the consensus in the central banking community was that it was appropriate to look through these kinds of shocks. However, that's much harder to do in the current context of having been through this inflationary episode. You drew parallels to the 1970s Paul, and I think you're right to play those down. But of course, the 1970s inflation shock was a variety of inflation shocks layered on top of each other over many years. And the concern would be that after this one inflation shock, you then get another, the central bank looks through that again, and inflation expectations start to ratchet ever higher. And there's rather than being a one-off level shock to the price level, what you end up kicking off is a series of second-round impacts as high energy prices, beget higher prices in the economy and so on and so forth. And so, I think it would be much more difficult for central banks to sort of act in that relaxed looking through it kind of way were we to see a big increase in energy prices. And obviously that would be particularly painful right now when many economies already feel like they are pretty close to being in downturns or recessions. And I think also that means that the market impact of this could be quite interesting as well. Typically, you'd associate the economic pain, the geopolitical risk uncertainty with lower yields but perhaps the much higher inflation, the fact that central banks would maybe have to tighten policy and increase interest rates, could push yields higher, so a somewhat ambiguous effect on the market there. But shifting gears somewhat Lizzy, obviously the US is acting as a security guarantor in the Middle East. So I wonder what are the political and fiscal considerations around ongoing US funding for Israel? And how in particular, does that interact with the war in Ukraine at the moment?
Lizzy Galbraith
So it's a very active political debate at the moment in the US. So unlike Ukraine, the US has a standing relationship militarily with Israel, that predates the war by some decades. So annually, Israel already receives about $3.8 billion of military aid from the US. And it also buys quite a substantial amount of weaponry from the US as well. Its Iron Dome missiles are jointly produced with the US. So unlike Ukraine, the Israeli military is already very well equipped. And crucially, the current scale of the war is much smaller. So yes, the US is increasing its aid to Israel and Biden has requested more funding to support that effort. But the needs of Israel and Ukraine are different, the scale of that need is different and actually, the way that politicians are seeing these demands is very different as well. So what we've seen Biden do is he's requested an additional $106 billion from Congress. 61 billion of that would be related to Ukraine. And 14.3 billion of that would be for Israel, the rest goes on border security and disaster relief. And that's really designed to make it a bit more palatable to some of the Republicans that are more sceptical on the Ukrainian portion of this. They basically get the Border Security funding as a trade off in this package. However, right now, support for Israel is probably higher in Congress than it is for Ukraine. And what we've seen the House do is try and split out the Israeli portion of this funding request and pass that as a separate bill. Right now, the Senate has said that they will not bring that forward. And Biden has said that even if that were to pass, he would veto it, he's not going to accept anything that isn't the full funding package. So at the moment, US political divisions are having a knock on effect on its ability to provide additional support in response to these conflicts. And we do know that US funding for Ukraine is in particular, running quite low at this point. There are some concerns that you're starting to see pop up around whether the US, just from a logistics perspective, from a manufacturing perspective can sustain demands from multiple countries at once. It does look like particularly if we remain in the base case, these concerns are likely to be fairly overblown. The demands that Israel and Ukraine are making of the US are different. They're asking for different weapons, different equipment. So there doesn't seem to be too much overlap. However, the tradeoffs become more complicated if the war were to expand. If we enter one of these escalatory scenarios. As then you probably see more overlap in the demands between Israel and Ukraine. And you will still have this ongoing divide in Washington around which country should receive aid as a priority and whether or not they should be considered as separate requests or as part of an overall security package. So right now, Washington is at a bit of an impasse on this. And we'll have to see whether the Democrats can persuade Republicans that the tradeoffs in terms of an additional very large funding request, Biden has already requested a large amount of money for Ukraine over the past year, is worth it to secure that additional funding for Israel.
Paul Diggle
Yeah, part of the Western kind of political and economic debate here is whether the US can afford to provide aid to both Israel and Ukraine at the same time and I think it is worth unpacking a little bitwhat ‘afford’ might mean in this context, because we have to be careful not to fall foul of the household analogy or indeed the household fallacy, which is a common kind of comparison, casually drawn between the finances of a sovereign country and a household. So, a household faces certain budget constraints, income, wealth, borrowing costs, which don't apply in quite the same way to a sovereign, especially a sovereign like the US with, you know, its own central bank issuer of the global reserve currency issuer of the global ‘safe’ asset in the form of the Treasury. So ‘afford’ is kind of a slippery and dangerous term here. Nonetheless, there are obviously constraints on the US’s ability to provide arms. They come from the current large size of the US budget deficit, elevated treasury yields - I mean they've fallen back a little bit actually over the past week or so, but they're still pretty high. The US debt servicing costs are pretty elevated. Our previous podcast was about many of the kind of macro market implications of this.
Also worth mentioning that when one talks about domestic spending, actually, the inflation consequences of government spending are also part of the constraints that the government faces and its ability to spend. But I think most fundamentally, the constraint here is in many ways societal and political. It's about what the polity wants to do, how it wants to mobilise its resources, which comes back, Lizzy, to the discussion you had there about how this all pans out between Democrats and Republicans, how those negotiations go. But I want to end with a final question, which is on Israel's aims in Gaza, and its exit strategy from the territory. I mean, in some ways, it's too early to think and talk about that. But what might Israel's presence in Gaza look like long term? What do we think this might mean for regional geopolitical stability?
Lizzy Galbraith
So there has been concern among some Israeli allies, particularly the US that Israel doesn't actually have a clear plan for, for what it wants. We know that it's been very clear that it doesn't want to leave Gaza until Hamas is no longer an operational political and military force in Gaza. But it's not necessarily clear what that means or how long that will take. So the aims of this in practical terms are still a little bit unclear. What Israel has been very clear about is that it's not seeking to occupy Gaza on a permanent basis, after it considers this operation to be complete. But it has said that a credible force will be needed to prevent the emergence of militant threats. Now, whether that means that you have a permanent military presence in Gaza to act as security guarantors, one that is not Israeli, but potentially is an international coalition. Whether or not one of the political entities from the West Bank is installed to govern Gaza, with the coordination of the Israeli government. It is not clear at this stage. But it is one of the very serious questions that Israel will have to answer as this conflict continues. And its international allies sort of demand more certainty from Israel as this wears on. This is something that the US in particular is very worried about. It is obviously a main backer of Israel, it is supplying quite substantial aid to Israel. But one of the key unknowns in this question that everyone is sort of grappling with right now is the political future of Netanyahu himself. He is currently the Prime Minister, he is at the head of an emergency government. That government is unlikely to last for a particularly long time after the end of this conflict. And then we're likely to see a reckoning about how the original Hamas attack on Israel was allowed to occur. And polling indicates that the Israeli public do blame Netanyahu as the head of the government for what happened. So his political future is very much in doubt. And I think one of the big things that is going to affect regional stability, and the future of Gaza, is actually what sort of Israeli Government emerges from that reckoning that Israel is likely to have after the end of this ground operation. What sort of government do we see emerge? Do we see a government that continues in the same vein as Netanyahu? Or do we see one that's actually more open to reopening debates around, you know, two-state solutions, entering into more dialogue with regional allies. That's a very big unknown at this stage. It's far too early to speculate about whether that will happen or how long it will take. But I think one thing to watch very closely is exactly how Netanyahu’s future plays out as that is a main driver of Israeli politics, which has been quite volatile actually, for some time before this.
Luke Bartholomew
Alright, well, I think that's probably all we have time for this week. So as ever, please do subscribe or review, and or review, I should say, on your preferred podcast platform. And all that remains is for me to thank Lizzy for joining us and to thank you all for listening. So thanks very much and speak again soon.
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