Opinion: Israel-Hamas war could be the tipping point for a fragile financial system

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It is naïve to assume that the largest credit-fueled bubble in half a century can continue indefinitely or be deflated without pain.

Talk show pontifications notwithstanding, the trajectory of the world’s two most serious geopolitical conflicts — Ukraine and the Middle East — is unpredictable. In the Israel-Hamas war, the potential for serious escalation is not trivial. These and other uncertainties are aggravating known stresses on the global financial system.

Consider inflation. Slowing price rises have been driven by easing demand, as consumers’ COVID pandemic savings dwindle and energy and food-price costs decline. While several factors suggest that inflation may stabilize at around current levels, it could increase for several reasons. 

First, on the demand side, strong employment will support consumption. Government deficits, currently around 5% and projected to grow, will add to demand. The energy transition, subsidies for strategic manufacturing, semiconductors and war-footing defense spending, will continue to boost spending.

Input costs show no signs of easing. While volatile, energy prices remain under upward pressure due to production cuts by Saudi Arabia and Russia to keep prices at levels which meet their revenue targets. Fuel hungry military activities will influence demand. The threat of an 1974-like oil embargo should not be discounted.

Food prices are affected by geopolitical conflicts, reducing supply from major producers, extreme droughts and floods as well as export limits as nations prioritize their domestic needs. Commodity prices, such as for copper, will be underpinned by demand for transition critical minerals and armaments. There are looming shortages due to inadequate investment  because of, in part, efforts to meet ESG targets.

Manufactured goods prices may fall due to excess Chinese capacity but services, which are a large portion of advanced economies, will reflect rising labor costs. Moreover, an aging population and skills shortages will drive higher salaries, in nominal but not real terms, generating a wage-price feedback loop.

Housing also is affected. With affordability at record lows, strong housing markets will feed inflation via real or imputed rents. Rising insurance costs due to increased extreme weather risks will flow into rising prices.

Inflation also is found in the tit-for-tat China-U.S. trade restrictions on technology and rare earths, which impacts supply chains. Relocating production facilities to enhance U.S. sovereignty will contribute to higher costs because of inefficient operational scale and higher inventories.

Second, public finances. Government spending, which will be affected by wars, is not being matched by higher tax revenues, leading to larger deficits and increased borrowing. U.S. government debt, for example, is forecast to rise to 107% of GDP by 2029 from its current 97%, exceeding the 1946 post-World War II historical peak of 106%.

Geopolitical conflict will divide the world, driving a shift away from the U.S. dollar.

Third, de-dollarization. Geopolitical conflict will divide the world, driving a shift away from the U.S. dollar
DX00,
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for trade and reserve assets to reduce exposure to U.S. sanctions and asset seizures. While unlikely to be replaced in the near term, the increased use of non-dollar currencies will fragment global capital movement. The U.S. will face increasing difficulties in financing its budget and trade deficit, now a combined 8% of GDP, from foreign investors, who hold one-third of US government debt, increasing borrowing costs. 

The effect of higher rates on financial stability and asset prices is underestimated.

Current interest rates reflect a long overdue normalization. Central banks also need scope to cut rates in an emergency. Barring a severe downturn or financial crisis, rates could remain at current levels for a prolonged period.

The effect of higher rates on financial stability and asset prices is underestimated. The banking issues revealed in March and April of 2023 have not disappeared. Long-term rates now are above levels when Silicon Valley Bank collapsed. Mark-to-market losses on bond holdings are now higher at around $9 trillion of losses. Deposit outflows are continuing. Loan losses from defaults as companies are forced to refinance with higher borrowing costs lie head. Write-offs would be compounded if the economy slows.

Recoveries in stocks, albeit narrowly based, and residential property have increased the levels of overvaluation as measured by fundamental measures. Weaker businesses with low- or no cash flow and reliant on constant capital infusions are especially vulnerable. Other areas of vulnerability remain, particularly among venture- and early stage capital, private markets, leveraged finance, shadow banking and structured products.

In addition, problems in commercial real estate and funds unable to navigate choppy trading conditions may foretell troubles ahead.

The tested meme of “bad news is good news,” with its promise of lower rates and additional liquidity, ignores this altered environment. The reality is that governments have unsustainable debt, and central banks must deal with bloated balance sheets and large losses on existing QE bond purchases. Policymakers are juggling accelerating geopolitical issues and the need to contain inflation.

It is naïve to assume that the largest credit-fueled bubble in half a century can continue indefinitely or be deflated without pain. Higher interest rates, if they continue for long enough, will force an adjustment, one way or another, to popular investments that were made based on comically low costs of capital.

Satyajit Das is a former banker and author of A Banquet of Consequences – Reloaded ( 2021) and Fortunes Fools: Australia’s Choices (2022)

More: 70% chance Israel-Hamas war spreads beyond Gaza, threatening oil, strategist warns

Also read: What Israel-Hamas war means for gold as investors seek safety

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