(Bloomberg) — The market fallout from the Middle East conflict is entering a new phase, with investors starting to shift their focus from the initial inflation shock to the hit on global economic growth, according to Citadel Securities.
The transition toward weaker activity and “demand destruction” could support longer-term inflation-adjusted bonds, strategist Frank Flight wrote in a client note Monday. At the same time, call options on the US dollar offer “attractive asymmetric” protection against further escalation in Iran, he said.
The comments came after President Donald Trump said Monday that he would delay strikes on Iranian energy infrastructure, a move that spurred a rally in stocks and bonds while oil and the dollar declined.
Even so, Flight cautioned that any de-escalation wouldn’t reverse “some lasting damage” to global supply chains following what the International Energy Agency has described as the worst oil-market disruption in history.
“Markets are forced to confront the reality of at least some demand destruction and the myriad butterfly effects of the conflict,” Flight wrote. “The next phase is likely to be defined less by escalation dynamics and more by the extent of the growth shock.”
Bond yields have surged across major markets since the war began in late February, as investors price in the risk that central banks may need to raise interest rates — or abandon easing plans — to counter hotter inflation as a result of higher energy costs. Meanwhile, the dollar has surged, benefiting in part from haven demand.
Once short-term rates stabilize, Flight said, real – or inflation-adjusted — interest rates will “flatten” in the forward market as investors start to focus on the growth damage from the conflict.
The strategist said the conflict is approaching a crossroads, with either escalation or a ceasefire possible — but both outcomes carry negative implications for growth.
A prolonged supply shock would hit an already fragile global economy, where consumers have largely depleted excess savings and labor markets are softer than during the 2022 energy shock following Russia’s invasion of Ukraine. If, on the other hand, growth proves more resilient, central banks are likely to tighten policy to contain inflation, ultimately weighing on activity.
Developing countries, many of which are energy importers, are particularly exposed, the strategist said.
Currency depreciation could force central banks to raise rates, amplifying domestic slowdowns. Weakness in emerging-market assets, then, may feed back into global growth while reinforcing dollar strength, intensifying the tightening cycle, he added.
Flight also warned that markets may be underestimating the scale of disruption. Shortages are spreading beyond oil to liquefied natural gas, helium and fertilizer, raising the risk of broader supply constraints, he said.
“We do not think that markets have fully internalized the second-order and ‘butterfly’ effects,” Flight wrote.
More stories like this are available on bloomberg.com
