When will the Hormuz recession hit? Our buffer is running out

After the US-Iran peace talks broke down in Islamabad over the weekend, oil prices rocketed. Then came news that back channels had kept communications going, and markets celebrated, with oil prices plunging and stocks nearing all-time highs.

Such violent mood swings have become a recurring feature of this strange war, reflecting Donald Trump’s whimsical decision-making. But one consistent theme has been that the US President would like to keep the war as brief as possible and has been frustrated by his inability to force it to a rapid conclusion. 

The Iranian regime, which has been prepared to absorb a lot of punishment, has used Trump’s impatience to its advantage, and still appears to believe that time is on its side. Nonetheless, it too is showing signs of exhaustion, with its negotiation team reportedly staying back to craft a fresh proposal after the Americans left. The resulting willingness of both sides to carry on talking has thus brought a wave of relief to investors. 

Still, we should hold our breath and hope for good news. There’s already a lot of damage baked into the economy — damage that will become more apparent, and more painful, as the year progresses. Everything now hinges on these peace talks succeeding. If they fail, things could turn south quickly.

So far, the economic harm of the war has been fanning out across the world gradually, at the lumbering pace of an oil tanker moving across the world’s oceans. It showed up first within the Gulf region, then in nearby Asia and Africa. It turned up in Europe last week, and this week began to reach the United States, with the last tankers to have left the Strait of Hormuz before the war broke out now arriving at their destinations. As a result, if the Strait is not reopened soon, refineries across the world will soon have to start cutting production. Should we reach that point, even the supposedly most sheltered economies, like the United States, will start experiencing shortages.

Given how badly the global economy was affected by oil shocks in the 20th century, it’s fortunate that panic-buying, long queues and energy rationing haven’t shown up in more places, being confined so far largely to Asia. After all, given that something like a sixth of global oil production has been taken offline, along with crucial exports of fertilisers and helium, the head of the International Energy Agency declared the resulting shock to the world economy worse than any previous energy crisis, including those of the Seventies. 

But what has softened the blow so far has been a buffer of oil accumulated by many countries prior to the war. Some countries, such as China and Japan, had long-standing strategic reserves. They and others have also benefited from the fact that it takes weeks for cargoes to reach them — again ensuring that shortages have taken a while to kick in. J.P. Morgan estimates that refineries have been able to run through those stocks until now, minimising the impact of the sudden shortage. But the Bank expects that, over the coming days, those buffers will run out. While $4-a-gallon gasoline may seem excessive to Americans, it may only be the start.

All this is contrary to the simplistic narrative that was circulating after the war broke out. The war’s victims, the narrative went, would be those countries which depended most on Gulf oil. China, by this telling, would suffer, whereas the US, since it was a net exporter of petroleum products, would come out a winner. But this isn’t how the war is doing its harm. What matters is not the scale of the shock to hit the economy, but its ability to absorb it. 

So, while China imports a lot of Iranian oil, it also accumulated large buffer stocks before the war and has been decarbonising its economy for years, giving itself considerable resilience. The country was thus able to absorb a temporary hit. Nevertheless, it now appears to have burned through its fat. The strains are beginning to show, with rising costs and supply shortages starting to affect the manufacturing powerhouse. Moreover, the impact on global demand is hitting Chinese exporters, which in March recorded a sharp drop from earlier in the year.

Although further removed from the conflict, many Western economies had less of a cushion to absorb the inflationary shock. The dependence of many European countries on natural gas supplies from the Gulf was rapidly exposed. Britain, which was already struggling with relatively high inflation and interest rates, has taken a particularly big hit, since consumers already struggling with rising expenses now face the added burdens of pricier petrol and steeper electricity and heating bills. And as for the US, its relative distance from the conflict, the stimulus of tax cuts and its status as a net exporter of petroleum products have given it some resilience. 

Nevertheless, it matters little that the US can gain a windfall off new oil sales, because the oil and gas sector accounts for a measly 1% of the country’s economy. Everyone else, not least the beleaguered manufacturing sector that Trump promised to revive, is facing higher prices, which are helping to both drive up interest rates and empty out wallets. Not only did the recent reports on Consumer and Producer Prices reveal US inflation shooting up on the back of rising energy costs, but inflation had already been rising in recent months, and not just due to energy prices. In short, this inflation problem probably won’t be transitory.

Price increases are manageable when outstripped by wage growth, but this is not happening in Western economies. Until now, American wages have stayed afloat on the back of lavish government spending, but it seems unlikely that a prolonged decline in real wages will not eat into consumption. Ordinary Americans hardly care that other countries have it even worse than theirs. They elected Trump to restore good jobs and bring down prices, but instead, prices are soaring, job growth is all but stagnant and real wages, which have declined since he took office, have now turned negative. That is, expenses are rising faster than paycheques can hope to meet them.

This helps to explain the recent collapse in consumer confidence, which last week was reported to have reached the lowest point ever recorded, with consumers expecting their finances to worsen and prices to rise over the next year, which will likely make their spending behaviour more cautious. As of now, the only thing propping up the US economy appears to be rich consumers whose incomes have been swollen by tax cuts and the wealth effect of a buoyant stock market. 

As far as that goes, the Trump administration has so far managed the messaging to investors fairly effectively, repeatedly sending signals that peace is around the corner and thereby minimising anxiety. This has helped to keep the market steady, which is for Trump the acid-test of his presidency and indeed of his conduct of this war, but at a possible cost: it buys more time for the administration to negotiate, in the hopes of securing the sort of surrender the Iranians are currently unwilling to contemplate; but it also prolongs the standoff. The markets haven’t collapsed, but nor has the Strait reopened, not least since the US is now enforcing a blockade of its own.

In the meantime, cracks in the wall of complacency are emerging. Goldman Sachs estimates that the rising cost of inflation will wipe out the stimulus from the tax cuts. That leaves the stock market to do the heavy lifting of keeping rich Americans spending. Expectations of a strong US earnings season, which just got under way, may well produce a rally in the next couple of weeks. But as the year progresses and the baked-in impacts of the war hinder the economy, the market could subsequently settle into a funk. In the best case, if the war ends very soon and normal business resumes, pent-up demand and damaged supply-chains could keep inflation higher than before, hurting the earnings of consumer-facing firms. In the worst case, if the war goes on for months, inflation and interest rates could rise sharply, potentially triggering a market meltdown and perhaps a recession. As it stands, Polymarket puts the chance of an American recession by the end of 2026 at around 30%. A prolonged war would raise those odds, and a market meltdown would probably push them over 50%. And in the event of a downturn, rising debt levels would make it hard for governments to commit to counter-cyclical fiscal policies without driving up interest rates and thereby choking off investment, while rising inflation would make it hard for central banks to cut interest rates.

Put it all together and we have a fragile European economy, a Chinese one whose export-engine may slow down amid weakening sales, and an American economy headed into possible difficulties. With the world economy looking decidedly fragile, it’s no surprise the IMF this week warned a re-escalation of hostilities could knock its growth down to the lowest levels since the pandemic.

Right now, optimism that an end to the showdown is nigh has kept oil prices from spinning out of control. Nevertheless, the gap between the futures market, where oil is trading at under $100 a barrel, and the physical market, where a barrel of oil now fetches $150, is growing huge. The first price reflects the hope the war will end soon, the second the reality that it hasn’t and the global shortage is worsening. 

That divergence can’t continue forever. If the peace talks fail and hostilities resume, the future price will move upward. If they succeed and the Strait reopens, the spot price will fall and everyone will be able to start rebuilding. All eyes will therefore be on Islamabad this week, to see if the peace talks resume and yield progress. If they do, we can resume breathing. But if talks fail and hostilities resume, we can head for the proverbial bunkers.

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