Geopolitics has taken centre stage in financial markets once again. As the risk of escalation in Middle East grows, oil prices continue to drift higher (breaching USD 93 level), raising stagflationary concerns for the global economy. Israel continues its air attacks in Gaza and prepares for a ground operation. Meanwhile, the US has seen stepped up drone attacks targeting its military bases in Iraq and Syria. Further underlining the risk of an escalation, fighting is also taking place in the north of Israel between the Israeli Defence Forces and Lebanon’s Hezbollah (Iran’s proxy), and in the Syrian border region.
In order to anticipate how the conflict may evolve from here, we think it is crucial to understand the geopolitical and cultural context in the Middle East, most importantly, the different religious factions within Islam. In our Geopolitical radar – Risk of escalation in Middle East, Xi-Biden meeting in November, tensions rise on Baltic Sea, 19 October, we analyse who benefits and who loses from chaos in Middle East. Overall, we hear echoes familiar from Arab Spring, and think that the long-standing conflict between Muslim Brotherhood (supported by Turkey and Qatar) and its opponents (mainly Saudi Arabia, UAE and Egypt) may end up playing a role in how political instability spreads in the region.
Apart from geopolitics, attention remains on the rise in long yields, driven both by a rising term premium and a stronger than expected macro momentum. This week, Fed chair Powell echoed the slightly cautious tone of his colleagues’ recent speeches, highlighting that the tightening financial conditions ‘takes some pressure off the Fed’ to continue hiking police rates and that the FOMC is ‘proceeding carefully’. Next week, the market will keep a close eye on the US October flash PMIs on Tuesday and the Q3 flash GDP release on Thursday. We expect the former to show gradual cooling in services sector activity growth, while any further upticks in the manufacturing index are likely to remain modest for now. We expect GDP to have grown by 3.3% q/q AR, driven by still upbeat private consumption and structures investment. While growth has remained stronger than we have anticipated for now, we still foresee weakening towards the winter not least amid tightening financial conditions, and think the Fed is done with hiking rates.
Next week’s main event will the ECB meeting on Thursday, where the Governing Council is widely expected to keep rates unchanged (see ECB Preview – Keeping a tightening bias with optionality, 17 October). As the ECB has opted to work with the ‘patience’ argument, it will now be crucial to follow the speed of the monetary policy transmission to predict their next move. If the speed is low, more patience will be needed and rates should be kept higher for longer, but if the speed is high, the first rate cut could come earlier. In this regard, the bank lending survey due on Tuesday will provide valuable input to this discussion through updated data on changes in lending standards and credit demand.
Flash PMIs will be released for euro area and the UK as well, we expect both to remain in contractionary territory across the board. We also get the rest of the UK labour market report on Tuesday after wage numbers were released this week. We expect the numbers to continue to show weakness as slack is set to gradually increase.
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