The “Strait of Disaster” for the Global Economy and Markets?

By Victor Sperandeo with the Curmudgeon

Executive Summary:

The global equity and high-yield bond markets are finally beginning to decline, in what may turn out to be major cyclical bear markets. The catalyst is the U.S./Israel war with Iran, the latter’s blockage of the Strait of Hormuz and its ongoing attacks on Persian Gulf countries. Unless this war ends soon (highly unlikely), it could quickly evolve into an economic and financial disaster.

A prolonged disruption of oil flows through the Strait—through which about 20% of the world’s oil normally passes—would represent the largest energy supply shock since the October 1973 Arab oil embargo and potentially the largest in history.

President Trump’s deployment of up to 5,000 Marines and possibly elements of the 82nd Airborne Division to the Strait of Hormuz marks a major escalation of the war. If this operation evolves into an attempt to dominate or seize portions of Iran’s Gulf frontage, the probability of a U.S. recession and a much deeper economic downturn in Europe and Japan rises sharply.

Reports indicate the administration may seek to assert military control over Iran’s maritime position near Kharg Island (Iran’s primary oil export terminal) and its eastern Gulf border. Should that intervention proceed, the likely outcome would be a U.S. recession—and a more serious European and Japanese recession or even a depression.

Here’s a chart (from Michael Gayed of the Lead Lag Report) depicting recession probabilities for several oil price levels:

Geopolitical Fall-Out:

A U.S. confrontation with Iran near the island of Hormuz would severely disrupt global energy flows. Iran still exports crude oil to China, and any interruption would significantly limit Beijing’s near-term access to oil supplies. China, even with substantial oil reserves, could respond aggressively—possibly by encircling Taiwan and initiating a de facto blockade of the island China claims as its own. Such a move would confront Washington with a dire strategic dilemma.

The topography around the Strait of Hormuz compounds the risk. The region’s mountainous terrain provides Iran’s Islamic Revolutionary Guard Corps (IRGC), estimated at roughly 50,000 troops there, with a strong defensive advantage. U.S. navy ships, aircraft carriers and destroyers would face extreme vulnerability (like sitting ducks). Iran’s Khorramshahr 4 missile, with a range of 2,000 km and speeds up to Mach 16, vastly outmatches U.S. destroyers traveling at 35 knots. Any major engagement in this area would almost certainly entail catastrophic losses—essentially a modern WW II D-Day scenario.

Lessons Learned from Prolonged U.S. Wars in Vietnam, Iraq, and Afghanistan?

Critics and observers point to several important, yet apparently unlearned lessons and strategic risks in the current U.S war with Iran:

l Reliance on Air Power/Lack of Exit Strategy: Similar to earlier arguments for limited engagements, some observers suggest the U.S. is relying heavily on air power to achieve regime change or collapse Iranian capabilities, a strategy that often fails to produce stable political outcomes.

l "Quagmire" Risk: Analysts, such as University of Chicago professor John Mearsheimer, have warned that a sustained conflict with Iran could turn into a "Vietnam-style quagmire" if it drags on.

l Ignoring Regional Dynamics: Critics argue that Washington has once again underestimated regional dynamics and the potential for a wide, long-term regional upheaval, reminiscent of the aftermath of the Iraq War.

l Overconfidence in "Decisive" Strikes: History suggests that America often favors military annihilation strategies, which may yield initial technical success but fail to address the long-term political complexities of the region.

l Ignoring the Need for Local Legitimacy: The lesson from Afghanistan is that military strength cannot create a stable, legitimate local government from the outside.

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Cartoon of the Week:

Image Credit: Economist

U.S. Political Implications and Monetary Policy:

In the U.S., such a conflict would have sweeping political consequences. A prolonged Gulf War could devastate the Republican Party’s standing, potentially shifting control of Congress decisively toward Democrats in the November mid-term elections. Conservative commentators and analysts already describe the situation as a “premeditated war of aggression.” If U.S. casualties mount, public support would rapidly erode.

Monetary policy won’t be of any help. Relations between the White House and the Federal Reserve have been deteriorating under Trump 2.0, limiting the scope for a coordinated economic response to economic weakness and financial market turbulence. Inflationary energy shocks combined with policy paralysis and surging oil prices could result in escalating inflation or stagflation.

Market Positioning:

Investors Business Daily (IBD) has a long history of recognizing shifts in stock market direction early to help investors maximize gains in uptrends and avoid losses in downtrends. IBD currently recommends (paywall) an equity market exposure level of 0%–20%, describing the U.S. stock market as being "close to breaking" as key support levels are tested or breached after three straight weeks of losses.

Strategic positioning favors long oil, gas and grains while shorting equities, though the latter trade carries significant geopolitical risk. Oil is made into fertilizer and the grains have rallied in sympathy with forthcoming shortages due to the high cost and unavailability of growing foodstuffs. As a result, energy and agricultural commodities are moving higher and that will likely continue as long as the Iran war persists.

Precious metals remain under pressure as the U.S. dollar strengthens, with the DXY index closing at 100.36 on Friday -the highest price in 10 months. Gold continues to discount tightening liquidity and the Fed keeping interest rates “higher for longer.”

-->Victor believes that unless the FED monetizes the oil price increases (via yet another round of QE), we will get deflation and gold is reflecting this so far.

Victor’s Conclusions:

The Strait of Hormuz has never been completely closed in modern history. If it remains closed, oil prices could easily approach—or exceed—$200 per barrel. Beyond markets, the implications would test the resilience of the post World War II global order itself.

Global markets now face a regime shift in risk and return, with close monitoring of energy shocks, economic weakness, and monetary policy. Expect elevated volatility across equities, interest rates, foreign exchange rates, and commodities.

End Quote:

War as a last resort from the U.S. Founding Fathers:

“They generally saw war as a measure of last resort, not a tool for expansion. James Madison and Thomas Jefferson emphasized that “the power to declare war is fully and exclusively vested in the legislature,” placing a check on the executive to prevent hasty or unnecessary conflicts. George Washington also stressed that “no offensive expedition of importance can be undertaken until after they shall have deliberated upon the subject and authorized such a measure.”

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Wishing you good health, success, and good luck. Till next time.

The Curmudgeon
ajwdct@gmail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever-changing and arcane world of markets, economies, and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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