Dire Straits

Thoughts on the economics of America's new Middle East war, what Pedro Sanchez gets right on NATO, why the West is being shut out of Africa, Brexit's 9th anniversary an Iranian history lessons

Photo by Jason Mavrommatis on Unsplash

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In this newsletter:

• Middle East War: Dire Straits

• Future of NATO: Spain’s inconvenient truth

• Out of Africa: Where’s Europe?

• Brexit anniversary: Sharing the Euro love

• Iran: History lessons

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1. Dire Straits

So much for the TACO trade. When Donald Trump said last week that he would wait two weeks to give negotiations a chance before deciding whether to bomb Iran’s nuclear facilities, some assumed he had Chickened Out again. Yet barely 48 hours later, the US president took the world by surprise when he sent stealth bombers to destroy Iran’s three main nuclear facilities. Clearly how this plays crisis plays out from here is a highly uncertain and depends in large part on whether and how Iran chooses to retaliate and whether Israel can be persuaded to de-escalate. A few thoughts on the implications for the markets and economy:

1. The first point to note is that the markets have barely registered this latest escalation in the Middle East. If you had gone away on holiday at the beginning of January and returned this weekend, you would have found the oil price at $72.40 a barrel a fraction lower than where it had begun the year, the S&P500 not far off a record high; and the 10-year US Treasury yield at 4.3 percent, just below where it had begun the year. The only significant price move in that time has been the downward drift in the dollar. This insouciance fits a long-established pattern, notes Deutsche Bank. Historically geopolitics has only had a wider market impact when it’s affected macro variables like growth and inflation. The only geopolitical shocks that have really mattered have been “stagflation shocks”, such as the1970s oil crises, the Gulf War in 1990, and Russia’s invasion of Ukraine in 2022.

2. Whether this crisis will turn into another one of those stagflation shocks depends on what happens to the oil price. Since Israel began its latest campaign against Iran, the benchmark Brent crude oil price has risen from $66 a barrel to $72 a barrel, consistent with some disruption to Iranian supplies to the global market. Current Iranian production is 3.4 million barrels a day, with exports of 1.7 mbd, most of which is shipped to China. But it is worth noting that prior to this crisis, most analysts were expecting oil prices to fall this year on the back of rising US shale production and increased output by the OPEC+ cartel. Goldman Sachs, for example, last week stuck to its forecast that the oil price would fall to $59 per barrel by the end of this year and $56 in 2026, assuming Middle East supply is not disrupted.

3. There are two major risks to Middle East oil supply. The first is that Israel attacks Iranian oil infrastructure in an attempt to cripple the government and bring about regime change. But given that Iranian production is such a small part of global supply, any shortfall could be easily made up by production elsewhere. Assuming Iranian exports halve, the oil price would probably remain at current elevated levels, reckons Deutsche Bank.

4. The bigger risk is that Iran tries to close the Straits of Hormuz, though which 20 percent of global supply flows. Deutsche Bank reckons this cause the oil price to rise to above $120 a barrel. Yet this risk is exaggerated, reckon Tom Holland and Tom Miller at GaveKal. “At this point Iran has no wish to pick fights with the Gulf states. And closing the Strait of Hormuz is easier said than done. Iran tried and failed during the “tanker war” of the 1980s. Even if it was achieved, though, closing the strait would be counterproductive. Most of the oil flowing through Hormuz goes to Asia, notably to China, which sources around half of its oil imports from the region. Iran can ill afford to antagonise China, one of its key patrons.”

5. As things stand, most economists think the risk of a stagflation shock arising from this crisis is modest. Goldman Sachs, for example, reckons that the 15 percent rise in the oil price since May, would shave around 0.1 - 0.2 percentage points off growth in Europe next year, while adding 0.4 percentage points to headline inflation. On the other hand, any severe disruption to shipping in the Straits of Hormuz could knock a further 0.4 percentage points off growth and add 1.8 percentage points to inflation. Under that scenario, central banks would face a difficult decision as to whether to “look through” the one-off rise to inflation, or take steps to guard against second round effects. Their decision-making would be complicated by the possible inflationary effects on the US economy of Trump’s tariffs.

6. As for the market implications of all this, Deutsche Bank notes that going back to 1939, the S&P500 has historically sold off by an average of six percent in the three weeks following a geopolitical shocks, only to bounce back over the following three weeks. Meanwhile there have been some evidence over the past week that the escalation in the crisis has reactivated some US dollar safe haven flows, reversing a trend since the start of the year of outflows in response to Trump’s trade wars and assaults on US institutions and the rule of law. That has led Goldman Sachs to suggest that the dollar decline may now be overdone. Finally, GaveKal suggests that if you want a hedge against a sharp long-term rise in the oil price, buy oil shares.

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2. Future of NATO

After last week’s debacle in Kananaskis, when the G7 became the G6 and the leaders of the West were unable to agree on a joint communique, NATO secretary general Mark Rutte is not taking any chances with the alliance’s annual gathering next week. In a bid to minimise the chances of another Trump walkout, the summit has been curtailed from a scheduled two days to just two hours - and there is only one item on the agenda: a proposed Trump-fluffing commitment by European alliance members to increase their defence spending to an eye-popping 5 percent of GDP from the current target of 2 percent.

Now even this agreement is in doubt, courtesy of Pedro Sanchez, the beleaguered Spanish prime minister currently under political fire amid multiple corruption allegations. In a leaked letter to Rutte, Sanchez rejected the 5 percent proposal on the basis that it would be “unreasonable and counterproductive”:

Strengthening European defence by increasing expenditure is “incompatible with our welfare state and our vision of the world,” Sánchez added.

The Spanish prime minister also questioned the validity of using GDP as a benchmark. “Capabilities are paid for with euros, not GDP percentages.”

The first thing to note is that Sanchez has a point. The new 5 percent target is a nonsense, cooked up to appease Trump in the hope that it will persuade him not to walk away from the alliance. It is split into two components: 3.5 percent of GDP for core defence spending and an additional 1.5 percent for “defence-related spending”. That is an open invitation for creative accounting. The UK has already expanded its definition of core defence spending to include the intelligence agencies. Now it is considering further widening the definition to include rural broadband, food prices, supply chains, crime and the internet.

Secondly, even the 3.5 percent number is an arbitrary target, picked out of thin air with no relation to underlying capabilities or how all this money will be spent. The reality is that EU member states defence spending totalled €326 billion in 2024 and is set to rise by another €100 billion by 2027. That compares to estimated total Russian defence spending last year of 13.2 trillion rubles (€150 billion).

What’s more, European alliance members had more than two million troops in mid-2024, according to NATO estimates. The US has 1.3 million and Russia has 1.3 to 1.5 million. Meanwhile, Israel, a country with a population of just 10 million, is redrawing the entire Middle East security order. Europe’s core problem is not so much that it does not spend enough on defence, but that what it does spend, it spends spectacularly inefficiently.

But whether Rutte’s 5 percent ruse will be enough to stop Trump from walking away from NATO is an open question. In reality, he is already turning his back on European security. Even if the US remains part of NATO, it seems almost certain it will start to reduce its military presence in Europe later this year. And Trump’s continued refusal to impose new sanctions on Russia shows a complete lack of interest in the fate of Ukraine, the single greatest threat to European security.

For Europeans, therefore, a far more important goal than appeasing Trump is to start preparing to defend the continent with less or potentially no US help. As Ian Bond argued in a recent report for the Centre for European Reform, what is needed is a new European defence pillar with real decision-making powers rather than just another talking shop, to stand alongside NATO and the EU:

A proper European pillar would provide a binding defence guarantee covering all its members, not subject to a US veto; a link to NATO’s command structure, Europeanised as necessary, to enable it to conduct operations; and a link to the EU’s defence industrial policy tools, enlarged to allow other European countries to benefit from them, to foster a pan-European defence industry able to produce weapons and munitions at scale.

If Sanchez wants to show that he is serious about European defence, rather than simply opposing the new spending targets out of political weakness, he should set out his own proposals for establishing this new European pillar. As discussed last week in the context of Bulgaria’s euro accession, in a world of deeply integrated European economies, to dismiss security threats to the continent on the basis that they are taking place far from your national borders is dangerously myopic.

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3. Out of Africa

Last week I wrote about the ASEAN-GCC-China summit which appeared to herald a new dynamism of Chinese-led south-south economic integration that would bypass the West. This week, the spotlight turns to another act of Chinese economic outreach to the Global South that similarly was largely missed by the Western media: Beijing’s offer to expand its “zero tariff” offer to all 53 countries in Africa that have ties with China, that is every African country other than Eswatini (formerly Swaziland) which recognises Taiwan.

That builds on Beijing’s offer last September to give the 33 countries ‘least-developed’ countries zero-tariff treatment. The trade offer was made alongside a 10-article declaration signed by China and African ministers urging the international community to prioritise Africa’s economic challenges. They stressed that development aid “should be effectively increased, not unilaterally slashed,” and called for “true multilateralism.”

What makes this offer significant is that it replicates what the deal that used to offer 30 Africa states but which Donald Trump looks set to rip up. The African Growth and Opportunity Act signed by George W. Bush in 2000 is set to expire in September and few expect Trump to renew it, not least because he is already breaching it with his 10 percent baseline tariffs. In April, he threatened many countries with even higher “reciprocal” tariffs, including a 50% rate for Lesotho, 30% for South Africa and 14% for Nigeria. They are now scrambling to offer deals, typically in the form of mining contracts, to convince Trump to spare them.

How much economic benefit Africa derives from this offer is an open question. Inevitably, China exports far more to most African countries than it imports, and much of what it imports is raw materials. The main beneficiaries may be Chinese firms that have set up operations in Africa to supply the domestic market. Even so, China’s share of trade with Africa has grown massively in recent decades. In 2003 just 18 of Africa’s then 53 countries traded more with China than they did with the US; two decades later that is the case for 52 of Africa’s 54 states.

All this points to a topsy-turvy irony in how the two great powers approach Africa. As the Economist notes:

Having spent years criticising China—with much justification—for exploiting Africa’s natural resources and using its power to extract concessions in a transactional manner, America is now doing just that. That allows China, however cynically, to present itself as the benevolent partner.

Meanwhile, where is Europe in all of this? What is the EU doing to enhance its interests in what Brussels has previously called its “sister continent”? asks EUobserver. Faced with the Trump shock, the EU has been accelerating its trade efforts around the world, EU-African trade relations have made little progress in the two decades since Peter Mandelson was EU trade commissioner:

While the EU executive hopes to start the ratification process on its deal with the South American Mercosur bloc, is fast-tracking talks with India, the United Arab Emirates and Indonesia, and hopes to join the Trans-Pacific Partnership, it’s so-called "equal partner" — the African continent — is nowhere in the queue.

Indeed, as a coda to a lamentation to dwindling European influence in Africa, it is worth highlighting that it is not just China that is benefitting from the Western retreat. Last week, Mali’s military junta, which seized power in 2021, started started building a gold refinery in partnership with a Russian conglomerate, the Yadran Group. That followed its decision to put a huge gold mine, run by Canadian giant Barrick, into administration, effectively bringing it under state control. The new facility is expected to process gold from Burkina Faso and Niger, who are also pivoted towards Russia after overthrowing civilian leaders.

It is a reminder that even if Russia’s economy may be on the brink of recession as a result of the Ukraine war, it continues to expand its geopolitical footprint and - alongside China - its influence across the Global South. That’s a big problem.

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4. Brexit’s 9th Anniversary

Next week will mark the ninth anniversary of the Brexit referendum, now widely regarded around the world as one of the greatest acts of self-sabotage by any state in recent history. A new poll by YouGov to mark the occasion finds that a clear majority of Britons now agree, with 56 percent now regarded the decision to leave the European Union has a mistake, compared to just 31 percent who still think it was the right thing to do. What’s more, 61 percent of Britons say that Brexit has been more of a failure than a success with only 13% seeing it as more of a success.

Of course, this may partly reflect the passage of time, as the Grim Reaper has taken his scythe to the predominantly elderly cohorts who voted to deprive younger and future generations of their rights and opportunities. But it also reflects the undeniable evidence that in economic terms, it not only did not yield the promised benefits but has done significant damage.

But rising Bregret in Britain coincides with a remarkable surge in enthusiasm for European integration across the continent, as confirmed by the most recent Eurobarometer survey published last month. It found that 52% of Europeans trust the EU, the highest level of trust since 18 years. The survey also registered the highest support ever for the euro, both in the EU (74%) and in the euro area (83%). It also found that more than 8 in 10 Europeans would like to see a stronger and more assertive EU through a common defence and security policy, while peace remains the value that best represents the EU.

The question is whether European leaders can capitalise on this tide of pro-European sentiment to deliver new initiatives that will make Europe stronger and more prosperous. So far this year, the evidence that the Trump shock will galvanise the continent’s governments to deliver what European Central Bank president Christine Lagarde has called a “global euro moment” by boosting its geopolitical capabilities and tackling its economic problems is hardly reassuring.

In Brussels, Commission president Ursula von der Leyen is currently facing a political crisis as she devotes political capital in her second term trying to dismantle the flagship achievement of her first term, the EU’s green new deal. Meanwhile, as previously noted (Poland’s MAGA President), it is alarming that by far the most powerful pan-European political force on the continent is the increasingly well-organised network of far right ethno-nationalist parties that campaign under the preposterous banner of Make Europe Great Again.

What this polling data shows is that European leaders do not need to be so timid. There is an opportunity for the continent’s mainstream leaders, including Britain, to do take bold and imaginative action. A couple of weeks ago, I highlighted two important initiatives relating to European defence and Ukraine (Europe’s Moment of Truth). This would be good week to announce progress on both.

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5. History lesson

Finally, if you’re looking for a crash course in modern Iranian history, I highly recommend these episodes of the Empire podcast series. What comes through most clearly is the dire record of Western intervention over the last 100 years. It seems extraordinary after the last two decades that anyone could seriously be advocating regime change as a western policy. Like the Bourbons, some in the West see to have learned nothing and forgotten nothing. On that score, I also recommend this essay for UnHerd by my former WSJ colleague Sohrab Ahmari, an Iranian-American, on the return of the regime change maniacs.