Macro Freestyle – Looking beyond the Middle East conflict

Hello, I'm Eric Robertson, Global Head of Research and Chief Strategist at Standard Chartered. And I'm Madhur Jha, Global Economist and Head of Thematic Research also here at Standard Chartered. Welcome to Macro Freestyle, our monthly podcast series where Madhur and I will identify and explore topics that are likely to be most impactful and relevant for financial markets and the global economy.

Welcome everyone to another edition of our podcast, which we are recording on the 23rd of June. We are almost halfway through the year where the headlines have been dominated by the conflict in the Middle East. So today we look beyond the Middle East conflict at what the next six months could hold for the global economy and financial markets.

Eric, do you see the signing of the peace deal between the US and Iran having a significant impact on financial market sentiment? Is the worst behind us and how should investors now be positioning themselves? I guess what we're wrestling with at the moment is the following tension.

On the one hand, progress towards the reopening of the strait, this memorandum of understanding that has been signed and people are looking to that as a precursor to a more tangible peace deal, I think is important because it does take away some of the left side tail risk. And I think the financial market response has been focused on that reduction of tail risk. Call it a reduction of risk premia, call it a reduction of possible black swan events.

And I do think that is important. Unfortunately, I think there's still quite a long ways to go in terms of both progress towards a peace deal that is viewed as a net positive, not only for the participants, but also the Middle East region on a broader basis. And the other lingering question is this issue of longer term economic damage or constraints.

And that could be how long it takes for oil and other commodities to be exported out of the strait. It could be the lingering effects of inflation. And I suppose the final comment I would make just to kick things off is that we're seeing many more central banks react to the prospect of inflation with tighter financial conditions.

And that injection of tighter financial conditions is, I think, adding another bit of risk back into the market. So yes, there's progress. Yes, there is certainly a sense that maybe we are past the worst, but I don't think that automatically means that we're back to normal either.

Metter, I guess the question that immediately comes to mind when I think about the Strait of Hormuz reopening is how to think about the normalization of not just energy flows, but also the broader commodity complex, whether it's aluminum, fertilizer, et cetera. And while we may assume that traffic will start to improve, it's not automatically or immediately going back to normal. And so the lingering inflationary impact of these price increases, I think, is still going to be with us for a while.

Give us your sense of how these supply disruptions will start to pan out. I think markets seem to have overshot a little bit in terms of how quickly prices have fallen, not just for oil, but also some of the other industrial inputs you mentioned. Fertilizers, you mentioned aluminum, prices have come off quite rapidly.

But in reality, the actual coming back of physical supply might take a lot longer. Our energy experts within the research team believe that only about 30 to 40 percent of oil supply through the Straits of Hormuz is likely to come back in the next few weeks. And it could take even up to a year for about 80 percent of the actual oil supply to come back for a variety of reasons.

In addition, if you're looking at things like fertilizers, clearly some of the worst fears have now been taken away. But in terms of priority about which kind of goods leave the Straits of Hormuz, then fertilizers would be most probably at the back end of the queue with energy supplies taking priority. So again, for things like industrial supplies, while we do see improving trends, we think that maybe markets have overshot a little bit and prices will remain supported and slightly higher than pre-conflict levels.

So even on oil, we expect prices to be about $10 a barrel higher than in the pre-conflict levels. So all of this adds up into higher goods inflation and higher food inflation, most probably. And we are beginning to see some of the impact already in terms of food inflation, where there is data on how farmers are leaving fields fallow, farmers are moving towards producing crops that require lower amounts of fertilizers.

So certain crops are seeing lower production. And so there is this real risk that agricultural output could see a shift and particularly some essential crops, some essential grains might see smaller amounts of production this year, which could then lead to food inflation, where emerging markets are particularly vulnerable because food tends to be a much higher share of their CPI basket. And this has cost of living implications.

So you mentioned the fact that the long-term economic damage is yet to be seen, and that's absolutely right. We are still to see what the implications of the higher energy costs are going to be, what the implications of all of these industrial inputs, seeing higher prices, if not actual physical disruption to supply. So yes, there is a positive development, as you mentioned, in terms of some of the disruption, hopefully now abating, but any normalization will take time.

And for that also, we need shipping confidence to come back, insurance premiums to be lower. A lot of things have to fall into place before we can really say that everything is back to normal. And I think that will take a lot more time.

So we are likely to see prices stay elevated. Eric, you've spoken about economic scarring and oil shocks can have long-term effects on the global economy. Do you see central banks now building this into their reaction functions?

Has the conflict significantly altered how central banks react? Or do you think that now that you have the peace deal, this allows central banks to be a lot more patient in terms of how they respond? There's a couple of ways to think about this.

The first is that there are going to be long-term ramifications of the crisis that we've been through. The first of which is that many economies around the world have been reminded that they are structurally short of key natural resources. And so even if we do start to see a normalization of supply chains, I would expect, and our commodity research team is also highlighting this, that many economies will now use this easing of tensions as an opportunity to rebuild or to build from scratch strategic reserves.

And that's not just of oil, but a number of key natural resources. Let's call that greater public sector participation in these markets for building reserves. So I think that's the first impact.

The second is that I think that this crisis will once again highlight the need for a number of economies to increase their commitment to defense spending. And we've already seen that starting to play out in Europe. It's obviously going to play out now in the Middle East.

For a fixed amount of GDP, if more money's going to building of strategic reserves of natural resources and more money's going to defense spending, then there's less money for other things. And I think that the composition of GDP is probably going to evolve a little bit. Government spending by nature will start to shift.

Now, what does that mean for central banks? I think the good news is that the reduction of risk premia and the reduction of some of the geopolitical uncertainty probably means that at the margin, central banks have a little bit more leeway to be patient. What has not changed is that I think the skew or the asymmetry of the distribution of outcomes is towards tighter conditions, higher rates and tighter monetary policy.

We've seen a number of examples of this already across both EM and DM, where central banks observing their inflation mandate have tightened monetary policy. Do I think we are now in a global rate hiking cycle? To some degree, I would say yes, there are a few DM central banks and a few EM central banks that are now finding themselves with a policy setting that is arguably too accommodative.

The final point I would make in terms of central bank reaction functions is that with the dollar having turned or the appearance of a turn in the dollar to stronger levels, we're seeing currency depreciation also being a factor in central bank reaction functions, right? Because not only you have the potential for commodity inflation, but if currencies are weakening, their import bills are going to go up as well, so imported inflation exacerbates the problem. And so I think you are going to see, especially in EM, central banks behaving a little bit more aggressively to try and contain the risk of that downward spiral.

So I do think forecasting and anticipating central bank behavior is going to be a key macro risk for the second half of the year. It's going to be very difficult to generalize because we do have some examples of policy easing still going on, but I think for the most part, we've shifted back to a rate hiking cycle. So Eric, staying with the second half of the year, what are some of the key events or themes that you feel could have a significant impact on markets?

Let's continue with this idea of central banks, the first of which is we have a new Fed chair in the U.S. with Kevin Warsh. We will all spend quite a bit of time trying to interpret and decipher his communication and his views on the policy setting. I would say that if the U.S. economy is going to achieve nominal growth in excess of 6% in the second half of the year, which looks very plausible, then I think markets will spend a lot more time discussing whether or not the Fed raises rates in the second half of the year.

Now, we still believe the Fed does not need to do so, but that's going to become a more aggressive topic of discussion. In Asia, we have Japan continuing to raise rates. That will be a key risk factor.

We have Korea set to raise rates in the second half of the year and potentially India as well. So this topic of central banks for major economies is key. China is in some ways in the opposite direction, right?

There's some evidence of a deceleration in the second quarter going into the third quarter. We may see more fiscal stimulus out of China. Let's see how that plays out.

Moving away from the economics, we have the U.S. midterm elections coming in November. I think it is fair to say that that is going to play a pivotal role in how people think about setting up and managing their risk into the final quarter of the year and into 2027. There are some key risk or uncertainty factors for how the U.S.

Congress shapes up going into 2027. And the next factor is a question that I'm going to turn back to you, Madhur, which is we're getting more and more questions about El Nino and the strong weather patterns that we're seeing. There is a growing fear or shall we say expectation that this will prove to be more and more disruptive to agricultural markets and therefore food pricing.

Give us a sense of what you're seeing in terms of this part of the landscape. Sure, Eric. I think this is going to become a question that gains a lot more attention over the coming weeks and months.

So El Nino by itself is not really very harmful because it's just broader year to year climate fluctuations. But what people are fearing right now is a super El Nino, which is when your surface water temperatures are about two degrees higher than normal. And that's very rare.

It's only happened about four times since the 1950s. The latest one being in 2023, very briefly. Now some of the research from previous episodes suggests that there can be long term scarring from a super El Nino.

The effects could last almost four to five years or longer. However, more recent evidence, we looked at what happened in 2014 to 2016 or in 2023, it would suggest that, OK, the global agricultural output does not really get impacted, nor do global food prices, because while output is impacted in a few countries, other countries actually benefit from better conditions and better climate. Now, what we do see more often and what is more likely to happen is that there will be regional winners and losers and there'll be regional impact.

So we've done our own analysis to see which countries look very vulnerable to a super El Nino, because now the weather forecasters are suggesting that there might be an 80 percent chance of a super El Nino developing data this year. And we've tried to analyze what the impact could be. And a few countries like Sri Lanka, Kenya, Pakistan, India, Colombia, they look a little bit more vulnerable, while others do not.

And this is not just vulnerability in terms of agricultural production, but your hydroelectricity supply could be impacted. You could have hits to infrastructure because of earthquakes or flooding. So there are lots of other things.

How ready are you to deal with a severe El Nino situation? But I think the bottom line of the analysis that we've done is that, look, El Nino is not going to directly by itself have an impact so much on the global economy. But what it can do is it can make the impact of the oil shock much more obvious.

Historically, oil shocks have had a very strong correlation with food inflation, much more correlated with food inflation than El Nino. And we've already seen the oil shock come through. And what El Nino could do is make that worse.

So that's what we'll be looking out for in terms of how things develop. Of course, these forecasts could change as to whether there is an actual super El Nino or not. But we would be looking at more regional gainers and losers rather than a more global impact.

Continuing with our thematics for the second half of the year, aside from food and energy inflation, what are some of the other broad macro thematics that you think need to be front and center for our clients on their radars? I think you've already touched on one of them, Eric, which is the U.S. midterm elections. And in my view, what would be very important is whether President Trump reignites the tariff wars.

What the U.S. administration is doing with the Section 301 tariffs, there's still investigations ongoing. We still have to get the results of what the actual tariff positions will be on trade partners and which trade partners will bear the brunt of these new tariffs. So that's one thing that could still maybe cause a little bit of volatility in markets, especially in the run up to the midterm elections.

The other one, which I think would be even more important, is what's happening on the AI investment side. Clearly, the AI boom has been very critical this year for not just growth in the U.S. and China, but also in the broader GCNA region. A lot of countries have benefited from it.

But is it possible that something undermines this AI investment optimism? Could it be, as you mentioned earlier, that expectations of tighter global liquidity and higher interest rates means that people expect less AI demand? So the supply side still looks OK, but there's less demand.

And does that mean that there's a recalibration of how much investment needs to come through? Could there be something like another deep-seek moment that rattles the markets into thinking, do we really need this kind of AI investment story to continue? Those are the key themes that I would be focused on, in addition to any geopolitical risks that we might be seeing.

But I think markets would react quite a lot to these two themes. And Eric, staying with the fact that the U.S. has benefited from the AI story, we have recently seen that this theme of U.S. exceptionalism, USD dominance, has made a comeback in conversations. Can you share with us your views on U.S. dollar?

Could you talk a little bit more about how you see the U.S. dollar and whether your views have changed markedly from a few months ago? The short answer is that our views have not changed. We've resisted the temptation throughout the year to turn explicitly bearish on the dollar.

We didn't buy into the narrative of de-dollarization. And we've held on to the view that we thought the U.S. economy was in better shape than people gave it credit for, and there may come a time during the year when the economy would start to outperform again. And we thought that also the Fed would be highly unlikely to cut rates.

So we thought there would be a turning point where the dollar would start to reassert its outperformance. And we've seen some early signals that that may be starting to play out. There's a second theme, which I think is really important vis-a-vis the dollar, which is that the correlations for the dollar appear to have changed.

And what I mean by that is over the last four or five months, whenever risk sentiment started to improve, and that could have been because of a perception that there was improvement in the crisis in the Middle East or other reasons, then the reaction was to sell dollars. So the correlation was risky assets up, dollar down. More recently, we've seen some evidence that that correlation has shifted where risk sentiment higher, dollar higher.

And as you correctly pointed out, some of that has to do with the fact that U.S. assets have been performing well again. There is some evidence that the willingness or the need to sell dollars, whether for asset position reduction or FX hedging purposes, has run out of steam and we're now starting to turn the other way. And I don't think the market is positioned for this.

And I say that because I think the desire to pursue and position for de-dollarization was extremely strong in the first half of the year. And part of it was for cyclical reasons, but more importantly, for structural reasons. And so I think there is still this legacy of wanting to sell dollars because of a frustration or a disillusionment with U.S. foreign policy, U.S. trade policy, et cetera.

But interestingly, the economic data is not supporting that. And I go back to the point I made earlier, which is that if the U.S. economy is going to achieve nominal growth in excess of six percent in the second half of the year, that's a very compelling story for not only economic outperformance, but U.S. asset outperformance and flows back into U.S. assets. And I think that should be supportive for the dollar.

So our view is the dollar will perform very well in the second half of the year. To pick up on a theme that you touched on, Madhur, we have seen a little bit of market fatigue with the technology and the A.I. narrative. We've seen some corrections in that space, and it will be very interesting to see what the dollar behavior is in response to that and whether we see the dollar continuing to outperform because of perceptions of a deterioration in risk sentiment.

So I guess what I'm driving at is that the correlations between FX and broader financial markets is an extremely important signal to pay attention to in the second half of the year. The final point I would make is that we're seeing more and more evidence that debt issuance is picking up, and that is true for sovereigns and it's true for corporates. And as we've talked about a few times on this podcast and in our research publications, we see a scenario where corporate and sovereign issuers are competing with each other in the second half of the year for marginal investor dollars.

And again, I think it will be very interesting to see how the debt markets respond to that, shall we say, avalanche of supply. I think it'll be very interesting to see how the dollar responds to the increase in duration that hits the markets. And so again, I think the U.S. is, from a debt point of view, obviously has some vulnerabilities, but so does nearly every other major economy around the world, right?

Debt issuance is a global theme. So understanding how the dollar reacts to that, understanding how individual currencies respond to their particular fiscal situations, I think is going to be a key risk factor and probably a key opportunity set for our clients in the second half of the year as well. Thank you so much, Eric.

Clearly, there's a lot to look forward to in the next six months.