The peace talks in Pakistan lasted all of 21 hours. Whether there will be another round remains to be seen. There were hints of more discussions, but nothing is certain. We can only hope that the ceasefire will hold while the rhetoric goes on, and no more lives will be lost.
From an economic perspective, the main concern is the long-range inflationary effect of this conflict. Prolonged negotiations or, worse, the lack of them, translate into lingering uncertainty. The markets hate uncertainty.
One thing we can be sure of is that oil prices will not suddenly snap back to pre-Feb. 28 levels. In fact, we have probably seen only a fraction of the impact of high oil prices on the global economy.
However this plays out, Iran is in a strong position, mainly because of geography – it controls the Strait of Hormuz, the gateway to Persian Gulf oil. U.S. President Donald Trump now threatens his own blockade of the strait, further adding to the confusion.
The U.S. must now try to salvage what it can from this mess, and it won’t be easy. Some of the most difficult issues, besides Hormuz, will be Iran’s continuing nuclear ambitions, the country’s missile program and Iran’s support of militant organizations such as Hezbollah and Hamas.
The original announcement of the ceasefire resulted in an immediate drop in oil prices, which produced some temporary relief at the pumps. But oil prices rose again when the fragility of the ceasefire became clear.
We saw the first statistical impact of the price increase when the U.S. released its March inflation numbers on Friday. They were up 3.3 per cent year-over-year, dampening hopes for an interest rate cut at the next meeting of the Federal Reserve Board.
The Fed will be watching the situation closely. Memories of the economic damage caused by the oil crises of the 1970s still linger.
In 1973, the OPEC countries declared an embargo on exports to the U.S., in retaliation for its support of Israel in the Yom Kippur War. Oil prices immediately rose 300 per cent, from about $3 a barrel to $11.50 a barrel (prices in U.S. dollars).
That seems dirt cheap today, but at the time it represented a severe shock to the U.S., which was still importing much of its petroleum requirements. The result was a global supply shortage. Prices at the pump jumped 40-50 per cent in the U.S. The high price of fuel led to a surge in inflation, which in turn produced a 0.5 per cent contraction in U.S. GDP in 1974.
That was just the beginning. In 1979, the Iranian Revolution, which brought the mullahs to power, triggered a second energy crisis. It turned out to be even worse. Oil prices rose from about $13 a barrel to more than $34 by mid-1980. Iranian oil production dropped by more than 4.8 million barrels a day, leading to severe fuel shortages and panic buying.
The second oil crisis caused a repeat of the high inflation and rising unemployment that followed the 1973 disruption – “stagflation” as it came to be known. At first, central banks struggled to keep interest rates down to promote an economic recovery. But the situation worsened, with inflation reaching 13.5 per cent by 1980. The Federal Reserve Board, under the leadership of chairman Paul Volcker, was left with no choice but to raise rates. The Bank of Canada and other central banks followed.
The medicine came too late. Inflation kept rising, invoking memories of the post-First World War Weimar Republic in Germany, where the value of paper currency collapsed. The U.S. federal funds rate peaked at 20 per cent in June, 1981, while the prime rate hit 21.5 per cent in 1982. In Canada, the five-year fixed mortgage rate hit an all-time high of 21.75 per cent in August, 1981.
As it turned out, that was the peak, although no one knew it at the time. Rates gradually started to edge down but they remained at double-digit levels for more than a decade and didn’t return to what we would consider “normal” until the mid- to late-1990s.
Flash forward to today. We have experienced another oil shock, even greater than those in 1973 and 1979. The U.S.-Israel strikes on Iran have resulted in the almost complete closure of the Strait of Hormuz, blocking the passage of about one-fifth of the global oil supply. Although the U.S. is self-sufficient in oil (as is Canada), gasoline, diesel and jet fuel prices are based on world prices and have soared.
The March inflation numbers are hopefully just a blip. But if tensions continue to remain high in the Middle East, we are in for a long period of uncertainty. Market watchers, who started the year expecting three quarter-point cuts from the Fed, now believe the U.S. central bank will hold at current levels, despite Mr. Trump’s repeated demands for rate cuts. In fact, he’ll be lucky to escape rate increases. The mistakes of the 1970s, when rates were held too low for too long, are a worst-case example.
Beth Hammack, president of the Federal Reserve Bank of Cleveland, said last week that interest rates in the U.S. could go either way this year. “I can foresee scenarios where we would need to reduce rates,” she told the Associated Press. “Or I could see where we might need to raise rates if inflation stays persistently above our target.”
Let’s not mince words. If a tightening scenario should play out, the impact on stock markets would be brutal. After the 1973 oil embargo, the S&P 500 fell about 48 per cent between January, 1973, and December, 1974. It wasn’t until mid-1982 when the market finally pivoted and went on a bull run.
We can’t predict with certainty what will happen this year, but the situation is not made easier by record high global debt levels. Rising interest rates combined with high personal, corporate and government leverage is a recipe for serious trouble.
In this situation, what are the best choices for investors? Here are some suggestions:
Energy
At one point, Mr. Trump appeared to suggest that as soon as the Iran war is resolved, the Strait of Hormuz will reopen, fuel prices will drop and we will quickly return to a state of normalcy. That would be nice, but it’s probably unrealistic. Iran and the Gulf states have lost some of their production, refining and storage facilities. That means oil prices are likely to remain high for an unknown period even if the ceasefire holds.
This suggests maintaining, or adding to, investments in quality energy companies. In Canada, names such as Canadian Natural Resources (CNQ-T) and Suncor (SU-T), should be high on your shopping list.
Fertilizer
Natural gas is the primary feedstock for producing ammonia, which is the base of most fertilizers. So, it should come as no surprise that the Middle East is one of the world’s major suppliers of fertilizer products, normally producing about 60 million tonnes a year. Most of that is now subject to what happens with the Strait of Hormuz.
Canada is well-positioned from a supply point of view but, like oil, prices reflect global markets. That’s why fertilizer prices are up about 60 per cent since the Iran war began. The result is a squeeze on farmers just as the North American planting season is about to begin.
We recommended Saskatoon-based Nutrien Corp. (NTR-T) in August, 2020, at $44.83. It’s now at $102.13 and still a Buy.
Gold
The price of gold dropped dramatically at the start of the Iran war. That was strange, because precious metals are normally seen as safe havens during times when real interest rates (nominal rate minus inflation) are negative. In that scenario cash and cash-type securities lose purchasing power.
For a pure play on the metal, we recommend SPDR Gold Shares ETF (GLD-A), which is up 10.3 per cent this year, despite a pull-back when the war started. If you prefer to own the miners, look at the iShares S&P/TSX Global Gold Index ETF (XGD-T), which is up about 20 per cent year-to-date.
Real return bonds
The principal and interest of these bonds increase with inflation. This acts as a kind of insurance policy against a rising cost of living. The FTSE Russell Real Return Bond Index is up only 1.31 per cent year-to-date but a prolonged rising inflation scenario would quickly change that picture. The iShares 0-5 Year TIPS Bond Index ETF (XSTP-T) recently touched its high for the year and pays a monthly distribution.
Value stocks
Generally, value outperforms growth in volatile times. Utilities like Fortis (FTS-T) and Emera (EMA-T) provide good cash flow although their share prices will come under pressure if rates rise. Discount stores like Walmart (WMT-Q), Costco (COST-Q) and Dollarama (DOL-T) are good bets when consumers are being squeezed.
Hopefully, we won’t have to contend with the worst-case scenario. But if we do, holding some of these assets may help soften the blow.
Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.