Iran War: Oil Prices Surge, Markets Brace for Stagflation Risk | Australian Economy Impact

Investors have grown accustomed to anticipating reversals from Donald Trump, particularly when faced with political or market pressure. But a week into the U.S. And Israel’s military campaign against Iran, a different scenario is taking hold: the growing possibility of a protracted conflict and the economic fallout that comes with it. The most immediate impact has been the disruption to global oil supplies, with the potential closure of the Strait of Hormuz – a critical waterway for roughly 20% of the world’s oil and gas – sending shockwaves through financial markets.

Brent crude oil prices have jumped 17% since the start of hostilities, surpassing US$85 a barrel. While the Australian sharemarket has been relatively insulated, it still experienced a 3.8% loss for the week. Asian markets, heavily reliant on imported energy, have fared worse, with South Korea’s stock market suffering its worst single-session drop in history, plummeting 13%. Wall Street’s S&P 500 index, however, has seen a more modest decline of less than 1% leading into Friday’s close.

Complacency and the Unknown Calculus

As the Trump administration considered tapping into the U.S. Strategic Petroleum Reserve to alleviate price pressures, Shane Oliver, chief economist at AMP, expressed concern that “markets are a little bit complacent.” He noted the surprisingly mild market reaction, attributing it to the expectation – built on past experience – that Trump will eventually de-escalate tensions. “Markets are assuming there will be some sort of backdown and this won’t be a long, drawn-out war,” Oliver said.

The core challenge for investors lies in the uncertainty surrounding Trump’s motivations for initiating the conflict and, what conditions would lead to its resolution. This has left markets pricing in a scenario of a sharp, but relatively brief, conflict lasting two to three weeks – a high-stakes bet, but one considered defensible given the historical pattern of Trump’s policy shifts. The Australian dollar’s resilience, remaining above 70 US cents, reflects this relatively sanguine outlook.

Ray Attrill, head of foreign exchange strategy at National Australia Bank, points to Australia’s position as a major energy exporter – through liquefied natural gas (LNG) and coal – as a key factor supporting the Australian dollar. “With oil prices in the 80s, the underlying assumption is that oil will start travelling through the strait of Hormuz sooner rather than later, and the large disruption will not last too long,” Attrill explained. Derivatives markets currently suggest a return of oil prices to the US$60s or US$70s range within a month. However, Attrill cautioned that a prolonged and larger shock could trigger a significant sell-off, potentially pushing oil prices to US$90 or US$100 a barrel and sending the Australian dollar much lower. Trump has warned there will be “no deal with Iran except unconditional surrender”, a stance that suggests a willingness to pursue a more aggressive and potentially prolonged conflict.

The Stagflationary Threat

A surge in oil prices carries significant stagflationary risks – pushing inflation higher while simultaneously hindering economic growth. This presents a difficult dilemma for central bankers, forcing them to choose between raising interest rates to curb inflation or easing monetary policy to support economic activity. While the current situation differs from the 1970s, when a doubling of oil prices led to double-digit inflation and unemployment in Australia, the potential for economic disruption remains substantial.

Jim Chalmers, Australia’s Treasurer, has warned of “substantial” consequences for both the local and global economies. Currently, the focus is on the impact of higher oil prices on inflation and interest rates. National Australia Bank economists estimate that inflation is now likely to peak at around 4.75% in the year to June, a half-percentage point increase from pre-war predictions. This calculation is based on current Brent crude prices. A sustained move towards US$100 a barrel could push inflation above 5%, reaching its highest level since late 2023. The Guardian reports on the potential impact of rising oil and gas prices on Australian bills.

Michele Bullock, Governor of the Reserve Bank of Australia (RBA), recently indicated that the RBA is closely monitoring the situation, particularly the risk that climbing petrol prices could solidify expectations of persistently higher inflation, making it more challenging to bring price pressures under control. The RBA typically looks past temporary price shocks, but Bullock suggested that this approach may not be appropriate in the current environment.

A Different Kind of Geopolitical Shock

Brett Solomon, a senior portfolio manager at QIC’s fixed income team, observed that investors have develop into accustomed to geopolitical headlines over recent years, often seeing them dissipate within a week. “What is different this time is that this could be longer lasting, and that could be a really big difference,” Solomon said. He currently maintains a view that the RBA will raise interest rates one more time in May, but acknowledges that this assessment is contingent on the evolution of the conflict and its impact on oil prices.

Kerry Craig, a global market strategist at JP Morgan, echoed this sentiment, stating that the “base case for most hasn’t changed: that this won’t be something that drags on for months, and the outlook for the global economy is fairly decent.” He added that a shift in this view would likely occur only if the conflict leads to a broader economic recession. The New York Times details how Trump’s decision to engage in military action against Iran was influenced by an Israeli leader seeking to end diplomatic negotiations.

What’s Next: Monitoring Oil and Inflation

The immediate focus for investors, central bankers, and policymakers will be on monitoring oil prices and their impact on inflation. A sustained increase in oil prices could force central banks to reconsider their monetary policy stances, potentially leading to further interest rate hikes. The trajectory of the conflict itself remains the key uncertainty. Trump’s recent statements, including his demand for “unconditional surrender” from Iran, suggest a willingness to escalate the conflict, raising the risk of a prolonged and more damaging outcome. The market will be closely watching for any signals of a potential diplomatic resolution or a shift in Trump’s approach.

Australian petrol retailers are already facing accusations of price gouging amid the rising fuel costs, as reported by The Guardian, adding further pressure on consumers and potentially prompting regulatory scrutiny.