The Iran war has upended all conventional assumptions in financial markets, as the blockage of the Strait of Hormuz has caused oil prices to nearly double to around US$120 ($154) per barrel, compared with US$60 before the Feb 28 attacks. As oil importing countries begin to run down their oil stocks, risks of a global recession are rising, as the International Monetary Fund (IMF) warned in its March 30 blog: “Although the war could shape the global economy in different ways, all roads lead to higher prices and slower growth.”
Financial markets are still slightly short of their record levels. As US President Donald Trump hems and haws over the next round of bombing on Iranian infrastructure, financial markets whiplash but the Dow Jones Index is 10%–11% below its record peak while the Nasdaq is 17% off, due mainly to uncertainties on the direction of the artificial intelligence bubble. Nevertheless, trading volume has come off to 20%–35% of peak volume, as higher uncertainty and volatility caused some investors to remain on the sidelines.
Meanwhile, the US bond market has seen US 10-year Treasuries rise to 4.35% per annum, and 2-year Treasuries rose to 3.8% per annum, slightly higher than the effective Fed funds target rate of 3.5%–3.75% per annum. In effect, the bond market is signalling higher interest rates going forward.
US Treasury Secretary Scott Bessent tried to assure the markets that the Iran war would be short-lived. On the other hand, European Central Bank president Christine Lagarde contradicted him, holding that this crisis will be more prolonged than expected.
See also: Oil trims gain, Asia stocks rise before Iran talks
Central bankers have long memories. Bessent made GBP1 billion for the Soros Quantum Fund when he was working there during the historic raid against the Bank of England in 1992. Now that he has turned from poacher to gamekeeper, overseeing US finances and the economy, he must steer a delicate path between supporting the Trump administration’s war on Iran and making sure that the US economy does not suffer too much from the unintended oil shock. To do this, he needs the support of the other central bankers, who hold a lot of US Treasuries.
The unenviable task that Bessent faces is not to do with the economy but the US$39 trillion of US government debt that must be financed, currently costing US$1 trillion in interest payments annually. The treasury must sell new bonds estimated at approximately US$11 trillion throughout 2026 to cover maturing debt rollovers (around US$9 trillion) and new deficit financing (about US$1.7 trillion). To do so, Bessent must keep interest rates low, which explains why he needs a new US Federal Reserve chairman who will do that.
Traditional central bankers do not like the fact that Fed chair Jerome Powell is being investigated to put pressure on him to step down earlier. This is eroding the independence of central banks to conduct monetary policy with relative professional objectivity, a pillar of monetary confidence. Thus, the European, Japanese and Chinese central bankers may not cooperate with the US to instigate another Plaza Accord agreement to depreciate the dollar as happened in 1985. Having offended almost all allies through insults and tariff sanctions, the allies and enemies alike will not cooperate that easily with the US to solve its structural imbalances in trade and exchange rates.
See also: Stock rally stumbles as oil’s rebound damps mood
With US military spending growing significantly, anticipated to rise from US$1 trillion to US$1.5 trillion (already US$200 billion has been asked for in the Iran conflict), Bessent is facing higher spending and little control over fiscal revenue since the Supreme Court has ruled the tariffs illegal.
Thus, the Iran war has brought events full circle. In the 1980s, the US was the unipolar power with the mighty dollar and military that engineered the beating back of the Japanese challenge in becoming the No 2 economic power and, by 1989, the collapse of the Soviet Union. Today, confronted with a mess in the Iran and Ukraine wars, foreign investors in the US are looking at power diffusion to a multipolar order and the daunting prospect of higher inflation, slower growth, higher US debt and therefore interest rates remaining elevated. This explains why the US bond markets are demanding higher yields for the higher risks and stock markets are wavering as to which way to go.
With the US hammering Europe on not joining the Iran war, prominent Europeans, including German economists Daniel Gros and Thomas Mayer, are arguing that Europe’s leverage may be marginal demand on their holdings of US Treasuries. Europe is the largest external holder of US federal debt (with roughly US$12.6 trillion in US-denominated assets, including Treasuries). Gros and Mayer argue that leverage does not come from the size of existing holdings or from a threat to liquidate them but from Europe’s role as a supplier of “marginal demand” — that is, whether European investors will keep on buying new US debt or assets over time. Indeed, if the US keeps on alienating foreign surplus holders, such as the Middle East oil economies, China, Japan and others, their de-dollarisation exercise will force US bond rates to go up, keeping the US dollar strong and essentially deflating the US economy
You do not solve a debt crisis by printing more debt. Either there is inflation or there is default.
For investors in East Asia, which is not involved in the Iran conflict, the opportunity lies in home bias, investing back in our home markets and friendly neighbours, hedging against excessive exposure in US assets. The Middle East oil-rich countries will also begin to diversify away from the dollar, as will Europe. Any neutral zone of peace and stable growth will benefit from the current turmoil.
The mantra in real estate investment has always been “location, location, location”. Malaysia and Asean are a zone of peace and strong growth. The mantra in portfolio investment is similarly “quality, quality, quality” — quality in creditworthiness, quality in earnings and quality in liquidity. Hence, in investing in local markets or neighbouring markets, look out for companies that are well-managed, with a coherent and well-executed strategy, proven technology and the ability to deliver growth and dividends. In volatile markets, the penny stocks will suffer most in low liquidity situations with higher interest rates.
This explains why stocks with high liquidity in stock turnover and that are well positioned in strategic areas (currently commodities, minerals and defence stocks) are doing well.
Warren Buffett has a deserved reputation for sagacity and shrewd stock picks. He is one-third cash at the moment. Follow the smart money.
Andrew Sheng writes on global issues from an Asian perspective. This story first appeared in the April 6 issue of The Edge Malaysia
