CIBC’s Senior Economist, Katherine Judge, interviews Chief Economist, Avery Shenfeld about the implications of the US-Israel and Iran war for the North American economy and financial markets. They explore how global markets—especially oil—are reacting to the conflict, what investors are pricing in, and the potential impact on North America’s economy, inflation, and monetary policy.
Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.
Katherine Judge: Welcome to the Eyes on the Economy podcast. I'm CIBC Senior Economist, Katherine Judge, and I'm joined by our Chief Economist, Avery Shenfeld to talk about the ongoing conflict in the Middle East. We and our clients are closely watching developments in Iran and its neighbors. And of course, we are hoping for an outcome that spares innocent lives and leads to a safer world that allows those in the region to pursue fulfilling lives in peace. But as economists, we of course are also looking at what the implications of this conflict might be for the North American economy and financial markets. And while these are early days, there are some clues to what lies ahead. So Avery, let me start with this broad question. What are markets telling us about what investors are assuming in terms of the implications of this war?
Avery Shenfeld: Well, certainly each financial market has its own reactions. We've seen some wiggling inequities, for example. We saw some significant selling in the treasury's market. But some of those are hard to figure out what exactly they're implying in terms of their assumptions of what lies ahead. In the bond market, for example, our own fixed income strategy team was puzzling over the fact that short-term bond yields had moved up a lot without actually that being driven by the inflation component in those yields. It was more of a real yield reaction, which didn't really make sense given the rise in oil prices. But the one market where you do get a cleaner read is, in fact, the oil market, because we can look at what oil has done. And I think we have to benchmark at this, not just in today's reaction, because of the buildup of expectations in the week leading up to this. We have to look at the full move in oil prices where we were trading around $60 a barrel and now we are more in the $70 a barrel range. So looking at that, what is that telling you? Well, obviously the market is anticipating some disruption in oil supplies, whether directly from Iran itself or the disruption in transportation through the Straits of Hormuz, but not a big disruption because otherwise we'd have actually seen oil prices jump significantly higher, in terms of the number of barrels they're assuming go away. But I found more interesting to look at the whole futures curve and look out to futures for December, that is for the end of the year, where the market is basically priced around $65 a barrel. So that's not really that far from where we were before this all started. Essentially, the market is saying, yes, there might be a short-term disruption that's more severe, but six months from now to a year from now, that has settled down, and most, if not all of the oil we would have been receiving on the market is back on the market again. And so the market, basically you could say the oil market is assuming this is a relatively short conflict, not a protracted one with a longer disruption in oil prices.
Katherine Judge: And why in your view might that view that's being taken by the oil market be right?
Avery Shenfeld: Well, I like to say I like to believe in the wisdom of crowds when there are multiple scenarios and you can watch CNBC or CNN and see all the various experts who won't exactly disagree, but markets have a way of synthesizing what might be the most likely scenario. And I think in this case, they may be on to something. First, if you look at Trump's past behavior, whether it was the effort in Venezuela, which just was a sort of a quick one-day thing, or the earlier bombing of Iran and its nuclear sites, Trump's proclivity seems to be to short-lived incursions, achieving some measure of success and calling it a victory. And there's other reasons why that might be the case in this particular instance. For one, of course, come November we do have the midterms. The early polls are showing most Americans aren't that thrilled with this idea. And they'll be even less thrilled if they start to see inflation moving up, driven by a protracted oil price shock. So all of that says that in terms of the voting behavior and public opinion, Trump has an incentive to move quickly. But there's also what the experts do talk about, which is sort of the missile count. In effect, the Americans and the Israelis will be keeping track of what percentage of their missile stockpile that they have used up in this battle, but also keeping track of what Iran has left. And they don't want to draw their own inventories of the weapons that they're using to intercept incoming missiles into Israel and some of the other Gulf states. They don't want to get that too low. And they want to keep an eye on how much damage they've done. And when that seems to be the right sort of balance where they still have some of their own defensive equipment left but have made enough erosion of Iran's ability to fire back, that's often where these sorts of conflicts end. And again, I think the president may be on to something saying, you know, this might be four or five weeks from now when they make that assessment. Now, of course, they won't necessarily have achieved the objective of regime change in Iran over that short period of time. There's reason to have some doubt about that. But to some extent, the administration has already laid the blame if they don't actually achieve that because they basically put it on the Iranian people to take that last step. That's going to be very challenging if this is only an air war. I can't think of a case where a regime was toppled solely from the air. And the fact that Iranian security forces have as many as a million people in total if you take the army, The Republican Guard, the police forces, and the people they have on the ground who basically are the ones who do the shooting of protesters and so on. There are hundreds of thousands of those local enforcers for this regime. So they may not achieve that objective and they might cut the war short, therefore, well before they've achieved that.
Katherine Judge: And Canada is obviously a significant exporter of oil as well as natural gas and has ambitions about expanding the sector. So how do you see this war impacting Canada's GDP growth in terms of both positives and negatives?
Avery Shenfeld: On the plus side, of course, our own oil exporters will be benefiting from at least a temporary period of higher prices. And I suppose some who decide that $65 a barrel for the WTIO futures price at the end of the year is attractive. They could obviously lock that in if they wanted to today. So there's certainly a plus in terms of the revenue flow. But I don't think there's a big impact either way on Canadian GDP because, for one, the bigger impacts come when you get big waves of capital spending. And again, if the oil market is right, this is going to be too short lived a period of elevated oil prices to do much to accelerate whatever the current plans are for expanding Canada's energy sector. And that's where you really create the extra jobs and GDP. And we do have to remember that there are also some negative impacts on the Canadian economy, a little bit more inflation facing consumers, which cuts into their spending power for other goods and services and potentially a bit of a hit to global growth from the uncertainty that this creates that could impact some of Canada's other exports. So yes, some wins for oil producers, some wins for aluminum because the price of that's also been lifted, but probably not a big impact on our forecast for Canadian GDP growth if this does end up being a relatively short-lived conflict.
Katherine Judge: And let's turn to inflation now and the implications for both the Fed and the Bank of Canada. How do you see that playing out relative to CIBC's base case, which has the Bank of Canada on hold and the Fed delivering two more quarter point cuts near the middle of this year?
Avery Shenfeld: Well, if it's going to affect either of them, it might be a bit more than the Fed, than the Bank of Canada, because inflation is already running a bit above the Fed's target. Core PCE prices are up 3% year over year. The target is, of course, 2. And while a one-time shock to oil prices that fades away won't do a lot of damage to that, because their economy is pretty close to full employment, they might be a bit more worried than the Bank of Canada that higher oil prices add some fuel to prices in the economy as a whole. But if we're right that this is a short-lived conflict, and if the futures market is right that oil is back in the mid $60 a barrel range in the second half of the year, then I think we're still on board with our forecast for two more quarter point cuts at the Fed around the middle of the year. At that point, they may have enough clarity that this was a temporary lift to oil prices rather than anything sustained. For the Bank of Canada, they are of course on hold. Inflation has come down quite materially in Canada, but more importantly, unemployment is more of a problem for the Canadian economy. There's more slack in the economy. So I think there's not likely to be much fear of extended inflation from this. There will be some impact on inflation because we're not getting the lift that historically we used to get when oil prices went up. We usually got some cushioning effect on overall inflation because the Canadian dollar also rallied and that pushed down some other import prices. We don't see that these days because in part you're comparing the Canadian dollar to the US dollar. The US is also an oil producer these days. And also because we don't get those big waves of capital spending. So a little bit of higher inflation in Canada, but I don't think that really changes the perspective that the bank is on hold. This is just another factor that they'll be watching. It is material though to their inflation forecast. So they tend to always assume in their published forecast that oil prices will stay wherever they are when they print that forecast. Well, when they did the last monetary policy report, WTIO prices were around 55 a barrel. So this is a pretty big move up. And I do expect that if we're still in the current range when they produce their next published forecast, we will see a material increase in some of their inflation readings, but probably not in their assessment of underlying or core inflation.
Katherine Judge: And we've been focused on one scenario, perhaps the most likely one at this point, in which we're only looking at a relatively short period of active combat. How wide is the uncertainty band around that base case scenario?
Avery Shenfeld: Well, this is where the world gets complicated for economists and for investors because when we're in the early days of a conflict like this, of course, there's a very broad range of plausible outcomes. So for example, if you look at what our energy sector equity analysts have put out from our sisters and brothers in the equity research department, they're laying out some scenarios where oil could be as much as $100 a barrel if there were significant disruptions in the Middle East, both in production and in transport through the Strait of Hormuz that continue to last. So there's quite a broad range in terms of the oil price shock that we might be facing, and therefore, of course, a fairly broad range in economic outcomes. And in addition to just the oil sector, remember that the Middle East is now a significant economic region, much more so than it was in the 1970s, where we might have thought of the Middle East as oil, oil, and nothing but oil. They have been diversifying their economies and they've also become a major market in terms of imports to that part of the world. And a slowing in economic activity in that region would have some macro consequences for the global economy. So these are early days. We hope that this podcast is still relevant. In fact, by the time it appears, we're speaking on Monday just for the record. So lots of news, as they say in politics, a week is a year in politics and that's true in geopolitics as well. So still lots of uncertainty and that's why we're going to stay close to this and we will be providing further updates if events diverge from the base case scenario of a relatively shorter conflict that we've laid out here.
Katherine Judge: With that, let's wrap up for today. We are likely to have more to say and write on this topic as the clouds of war lift a bit and as we gain greater clarity on where this conflict is headed. Thanks to all for joining us on this edition of our podcast and we look forward to speaking to you next time. In the meantime, we'll be keeping our eyes on the economy and calling it as we see it.
Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.
Disclaimer: The information and data contained herein has been obtained or derived from sources believed to be reliable, without independent verification by CIBC Capital Markets and, to the extent that such information and data is based on sources outside CIBC Capital Markets, we do not represent or warrant that any such information or data is accurate, adequate or complete. Notwithstanding anything to the contrary herein, CIBC World Markets Inc. (and/or any affiliate thereof) shall not assume any responsibility or liability of any nature in connection with any of the contents of this communication. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice. CIBC Capital Markets is a trademark brand name under which different legal entities provide different services under this umbrella brand. Products and/or services offered through CIBC Capital Markets include products and/or services offered by the Canadian Imperial Bank of Commerce and various of its subsidiaries. For more information about these legal entities, and about the products and services offered by CIBC Capital Markets, please visit www.cibccm.com. Speakers on this podcasts are not Research Analysts and this communication is not the product of any CIBC World Markets Inc. Research Department nor should it be construed as a Research Report. Speakers on this podcast do not have any actual, implied or apparent authority to act on behalf of any issuer mentioned. The commentary and opinions expressed herein are solely those of the individual(s), except where the speaker expressly states them to be the opinions of CIBC World Markets Inc. Speakers may provide short-term trading views or ideas on issuers, securities, commodities, currencies or other financial instruments but investors should not expect continuing analysis, views or discussion relating to these instruments discussed herein. Any information provided herein is not intended to represent an adequate basis for investors to make an informed investment decision and is subject to change without notice. CIBC World Markets Inc. or its affiliates may engage in trading strategies or hold positions in the issuers, securities, commodities, currencies or other financial instruments discussed in this communication and may abandon such trading strategies or unwind such positions at any time without notice.