Merlin Weekly Macro: Raging wars, calm markets

Move on, move on! Nothing to see here! Move on!

There are now two simultaneous clearly-defined state-on-state conflicts under way. The one between adjacent neighbours Russia and Ukraine has been running for more than three years and is now accepted as the status quo with no end in sight. The other, only a week old, is between Iran and Israel, separated by a thousand miles of other sovereign territories (Jordan, Syria, Lebanon and Iraq) lying underneath the drone/missile/jet flightpath and potentially in the firing line.

Who knew?

With the exception of a moderate reaction in oil and gas prices, the proverbial Little Green Man landing from Mars looking with no prior knowledge at most of the other barometers of investor sentiment, would be hard pressed to realise that anything of substance had changed since Friday 13 June. Brent crude has risen 11.7% from $69 per barrel before Israel began sending missiles winging their way to Iran a week ago, to $77 at the time of writing. We last saw $77 in mid-February; it had traded in the $70-80 band for most of the period since last July, so far nothing like the reaction to Putin’s invasion of Ukraine in 2022 when the price rocketed from $90 to $120. Wholesale gas prices have recovered around 14% back to where they were in April when Trump’s torrent of tariff announcements was in full-flow and investors were worried about the potential effect on the world economy.

Other than that, markets remain sanguine: equity indices and bond yields have shown little reaction, and the dollar has hardly budged. Usually under such circumstances there would be a flight to safe-haven assets (in the market lingo, “risk off”: typically selling equities, buying US and German government bonds and weighty currencies such as the US dollar). Going back five months, markets were much more exercised about Trump’s trade tariff chaos than they are today about the febrile physical situation engulfing the Middle East.

TBD

There are competing schools of thought as to why the reaction has been so muted. But all have added up to the same outcome: sit tight and do nothing. Here are three varieties of opinion. Clairvoyant markets are ‘pricing in’ (i.e. assuming they know) that based on previous events (the Hamas, Hezbollah and Houthi attacks since 2023 and the Israeli and international responses; Trump’s cruise missile shower against Syria in 2017; the Arab Spring; Gulf Wars etc) either a diplomatic solution will be found and the situation will de-escalate with few if any global economic effects, or any military solution will be contained, concentrated and quick. A second would be that whatever happens to Iranian energy production, while the world has abundant oil stocks and Saudi has the capacity to ramp up output, any disruption to global crude supplies is likely to be minimal, therefore until there is a demonstrable problem (e.g. Israel destroying Iran’s oil infrastructure or Tehran succeeding in closing the Straits of Hormuz through which 20% of global oil shipments pass), there is little to worry about. Finally, nobody knows how this will play out: while keeping an anxious eye, do nothing until there is a need to do something. TBD: To Be Decided; Too Bleeding Difficult; it falls into both versions of the acronym.

Right hand orbit

Perhaps it is more pertinent to say that everyone is in a holding pattern, awaiting the outcomes of a series of events yet to be concluded.

The majority of the principal central banks are on hold. The Federal Reserve, the Bank of England and the Bank of Japan seem reluctant to give direction with interest rates while economic growth is under pressure but unhelpful inflationary momentum remains. Out of sync, the ECB met at the beginning of June: with inflation in line with the 2% target it chose to cut by a quarter point but indicated that the rate cutting cycle is near its end.

Markets are holding, contemplating what might be negotiated by the United States with its various trading counterparties, much the most important of which is China, between now and 8 July when Trump’s 90-day tariff cooling-off period expires. Most enigmatically, in the game of will-he-won’t-he, having left the G7 (more accurately the G7-1, or in Trump’s view thanks to the enforced post-invasion absence of Putin, the G8-2) to stew in its own irrelevance, Trump has everyone guessing whether the US is going to join Israel in pulverising Iran and what the consequences might be.

Axis reactions?

Leaving aside what might or might not happen in the immediate future that brings the Iranian regime either to its senses or its knees, it is the geopolitical and strategic dynamics which are deeply fascinating and potentially in flux. Part of the Axis coalition, Iran is a cornerstone ally of both Russia and China, and has had extensive dealings with North Korea swapping ballistic missile and nuclear technological knowhow. All have remained stonily silent since Israel launched its pre-emptive strike.

Iran is the key third-party supplier of kamikaze drones to Moscow. It was Moscow and Tehran who jointly filled the strategic vacuum in the Middle East when the West abandoned it in the aftermath of the Second Gulf War ‘Weapons of Mass Destruction’ scandal and the Arab Spring. According to Iran intelligence specialists Kpler, in 2024 90% of Iran’s oil output went to China; around 16% of China’s consumption is provided by Iran. Iran is key in determining the future coherence of China’s One Belt One Road infrastructure project as to whether it is the seamless New Silk Road heading to Europe and Arabia, or a central Asian cul-de-sac.

Adapting Newton’s Law, “for every action there is an equal and opposite reaction”, it would be inconceivable that Russia, China and North Korea would not in some way react were there a major change forced upon Iran that impinged on their own security and interests.

Trump takes on Washington and Tehran? 

The domestic political risks for Trump are considerable. He campaigned specifically emphasising the avoidance of armed conflict involving the United States. Were he to authorise US participation in Iran, his supporters would say he is showing robust leadership; his critics and enemies would counter that he is exceeding his authority. The Constitution is clear: unless the US has been ‘attacked’, it is Congress which mandates war, not the President (his authority as C-in-C is derived from Congress). If he joins Israel as a combatant without a mandate from Congress, and the administration’s lawyers are unable to convince Capitol Hill and the courts that America has been under assault by Iran (define ‘attack’ in today’s oblique, hybrid and asymmetric conflicts where the protagonists are adept at covering their tracks) such that Presidential Decree is not only inappropriate but illegal, a policy of ‘permission first, forgiveness after’ will be unlikely to wash. If anything could see him impeached, this could.

Whatever the domestic political tensions, for regional stability the US and Israel must have a plan for what follows. Having started the job of destroying Iran’s nuclear capability, it needs to be demonstrably completed. Even if there is a popular uprising against the theocracy provoking regime change, it would be unwise to assume that because the populace is against the government it is friendly towards the United States and Israel. It would be the height of folly for either or both countries to bomb Iran to bits and then simply to walk away leaving a heap of physical and political rubble. Such an approach was an abject failure in both Iraq and Afghanistan. The resulting political vacuum needs careful managing.

Huffing and puffing

The United Nations, the EU and the G7-1 are impotent and irrelevant. There is very little to suggest that anything they say (for they will do nothing) will have any bearing on unfolding events.

Finally, as if it were not obvious before, The Donald’s Diplomatic Demo in Canada tells you everything you need to know about the relevance of his allies to him and the contempt in which he holds them. He left the G7 summit early making it very clear he had more important things to do, and a break in the Rockies was a waste of his time. His response to a journalist on Air Force One on the way back to Washington about President Macron putting words in Trump’s mouth will go down in the annals: “Yeah, that’s Emmanuel. Nice guy but he always gets it wrong”.

Dutch courage

The international bandwagon moves on to The Hague next week for the annual NATO summit on 24-25 June. Trump will be there. Stand by for the fall-out: it will either be a diplomatic and defence disaster and they fail to meet the proposed spending targets of 3.5% of GDP on core defence and 1.5% on cyber and infrastructure, or several heads of government will be heading home facing a significant fiscal and financial headache as to how to pay for it.

But however unpopular it is to say, it is Ukraine and Israel which are buying time for the rest of the West to catch up. When you face an existential threat, as they both do, you don’t muck about; you take control as far as you can. Israel has undoubtedly taken a big risk; but with an explicit and enduring threat of annihilation against it and Iran on the cusp of having the means to achieve it, Israel’s pre-emptive strike is entirely rational. Theirs is not a nil-sum game; their intention is still to have something left because the possibility of something is better than the certainty of nothing.

These conflicts are all dislocated from the West. We see them real-time on the telly and in thirty-second soundbites on our phones but the real experience is far removed: it happens somewhere else far away. What most of the West, especially those furthest from the front line, still cannot comprehend is that this potentially can happen to us too. That’s why this NATO summit is important, why Secretary General Mark Rutte is doing the rounds of members’ capitals telling their leaderships to get a grip and inject some urgency: “spend 5% or speak Russian”. Two-and-a-half points of GDP and a commitment short of the mark, Keir Starmer and Rachel Reeves are high on his target list. Their Linguaphone Russian lesson vouchers are pinned with a fridge magnet, just in case.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.