Market fears Israel-Gaza conflict will spread

It’s stormy outside, it’s October and the financial markets have jitterbugs. Share prices around the world are on the slide while bond yields – particularly in the US and the UK – soared to their highest levels for more than 18 months. 

Those of us of a certain age remember all too vividly the similarly gusty weather and financial conditions which came together exactly 36 years ago today on October 19th, triggering a global stock market crash leading to Black Monday and sparking fears of another Great Depression. 

Then it was the prospect of higher interest rates and ballooning US trade and budget deficits which led investors to dump shares and other assets as they feared they were over-valued.

Sounds familiar? This time though the cocktail is far more potent because of the dangers that the horrendous conflict between Israel and the Hamas-led Gaza will explode into wider geopolitical tension, if not war on several fronts. What’s been surprising is that until President Biden’s visit to Tel Aviv, coinciding with the bombing of the Gaza hospital, the markets have been remarkably resilient, if not calm. Even the oil price – always a key barometer of Middle Eastern conflict -stayed relatively stable after that fateful pogrom launched by Hamas against neighbouring Israelis on Saturday October 7. 

Not anymore. The tensions unleashed by the now discredited accusations that the Israelis bombed the Al-Ahli hospital on the Gaza Strip have upped the tempo, leading to fears that the latest horrors may well extend beyond Israel’s borders. In the wake of the bombing, oil and gas prices have been shooting up again, prompting fears that if sustained, higher fossil fuel prices will have a huge inflationary impact just when central bankers had hoped prices were coming under control. 

Investors are caught in a dilemma: higher inflation suggests that interest rates will stay higher for longer than hoped which will in turn curtail growth, risking a recession. It’s that prospect which has led to the bond sell-off, which pushed up the 10-year Treasury yield this week to 5 per cent, the highest in 16 years, and 30-year yields to 25 year highs. In the UK, the 30-year gilt – once deemed as one of the safest assets on the planet- is now yielding 5.08%, its highest return since 1998 while the 10-year gilt yield is also touching 15-year highs, at 4.7%.

Even before this latest crisis, markets have been on a knife-edge, struggling with the surge in government borrowing because of sky-high debt being raised by central banks to fund public spending. Quite rightly, investors want to be paid more for the higher risks they take in buying government debt, particularly in the West. It’s these fears of slower growth and even recession which are now bugging the stock markets too. 

Figures from the Institute of International Finance show that over 80% of the $10 trillion rise in global debt in the first half to a record $307 trillion came from developed economies: the US is drowning in the stuff, as are Italy and Britain specifically among the G7 nations. It’s these fiscal stresses and strains which are behind the bond sell-off, and resulting higher yields. 

In the US, the budget deficit in the fiscal year 2022-23 fiscal year topped $1.7 trillion and, if you include the impact of the cancellation of student loans, the deficit is nearly $2 trillion. Both the US and Britain are now in that illustrious club of having levels of debt sitting at around 100 per cent of national output although Italy leads the pack with an astonishing debt to GDP of 140 per cent. Germany, by contrast, although struggling, has just 60 per cent debt to GDP although that will rise too as growth stalls. The country’s interest payments are already up 10-fold since 2021 to nearly 40 billion euros this year.

So it’s no surprise that fears of the Middle East war escalating to the region are making it even more expensive for governments to borrow. And it’s hardly a surprise that instead of going for the usual safe as houses bonds, investors have turned to gold – as they nearly always do in such times of crisis – pushing it to two month highs. Gold bug Peter Hambro adds that in times of stress, people prefer the real thing as the value of money is falling. “Remember the rule,” he says, “He who has the gold makes the rules.”

If the Israeli-Hamas war does escalate, then it’s inevitable that there will be even more US government spending on boosting the military and defence complex. The US has already spent $75 billion on its support for Ukraine so another reported $10 billion or so of military aid to Israel is not going to bust the budget deficit by much more. On his visit this week, Biden promised more aid although this has to go through Congress and without a House speaker, there may be a delay. 

But Congress is unlikely to stop the aid as America’s Middle Eastern policy turns on Israel’s regional military hegemony, and the US will pay what it takes.  Over the last seven decades, the US has sent Israel more than $120bn in military aid,  according to the Congressional Research Service.

This year alone US military funding to Israel topped $3.8bn, as part of a record $38bn deal over 10 years signed under former US President Barack Obama in 2016. Figures given by Aljazeera claim that of the $3.8bn military aid provided to Israel this year, half a billion has been for Israel’s missile defences. 

While the US is Israel’s biggest donor, Israel is a pretty big spender on its own account. Indeed, Doug McWilliams, economist at Cebr, says that it’s a myth that Israel depends on the US and the West for funding. The numbers suggest they are perfectly capable of spending their own money: Israel spent $23.4bn on its military last year, according to the Stockholm International Peace Research Institute, roughly 4.5 percent of its GDP on  the military, the 10th highest percentage in the world. This is equal to $2,535 per capita over the four years to 2022, making it the world’s second-biggest spender on military per capita after Qatar. It’s also a big arms exporter, mainly to India.

Over the last three decades, Israel has become a wealthy country, creating a niche as one of the world’s leaders in cyber technology, drones and other military warfare. Ironically, much of this cutting edge research which has gone into developing its military technology has spilled over into being used and adapted in other technologies such as bio-tech and the life sciences. 

Indeed, Israel has some of the world’s most innovative scientists and engineers, many of them drawn from the cohort of Russian Jews who emigrated to the country after the fall of the Berlin Wall. In his book, the Flat White Economy, McWilliams points out more than 12 per cent of Israel’s working population – which has doubled over the last few decades because of immigration – are now involved in technology of some sort.

Yet despite this relative success, peace eludes them and their neighbours. While Biden – and Rishi Sunk – have both given their whole-hearted backing to Israel’s Benjamin Netanyahu and his planned ground invasion, it does appear that they are also calling for restraint among their Arab partners to avoid retaliation from hostile actors such as Iran. Biden’s comments on the lessons to be learnt from 9/11 were apposite.

They are right to do so. The risks to blowing up the region, which would inevitably lead to thousands more innocent civilians being slaughtered, are too great to contemplate. As historian Niall Ferguson, who has been warning since Biden’s election that we risked going back to the 1970s, wrote in the latest Sunday Times, this conflict could be the hinge that opens the door to a rerun of the 1930s. “If Israel finds it cannot contend with a three-front war in Gaza, the West Bank and Lebanon, and turns to the United States for military help against Iran, we shall have reached one of history’s hinges. The future of the world will turn on it.” It’s up to Biden to lead the way by making sure that hinge stays closed. 

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