Overnight, Israel launched air attacks on Iran targeting Teheran’s nuclear programme. IDF has reported it killed at least three of Iran’s senior military leaders. It has taken place a couple of days before US and Iranian officials were set to attend a sixth round of nuclear deal talks scheduled for Sunday in Oman. In retaliation, Iran has launched some 100 missiles at Israeli territory.
How should we interpret the above?
Without wishing to sound dismissive – or complacent – of latest events, it’s not unreasonable to see this as a way for the US to indirectly apply pressure on Iran, via Israel, ahead of these talks. The US denies any participation, but acknowledged it was briefed on the attack. To conduct such an operation would have required certain military assistance (e.g. refuelling tankers) and other capabilities the US is well-equipped to provide.
The more important question now is does this escalate?
Unlikely. Iran is a dictatorship whose principles are built on a religious doctrine. Its survival is at stake. Iran has more to gain by hanging in there and delaying its nuclear aspirations than to do something risks accelerating its own existential demise.
In the short term, it simply does not have the level of airpower needed to fend off Israeli air strikes. Furthermore, the geopolitical makeup in that region has changed: the three Iranian proxies (Hamas, Hezbollah and the Houthis) have all been severely weakened. Further afield, Russia – an ally of Iran – is very much on the backfoot (the recent drone attack by Ukraine was a real blow to Moscow and the supply of the Patriot defence system, by Israel, to Ukraine was also a game-changer). All this has severely weakened Putin’s negotiating power and with it his ability to step in and support Iran while he focuses attention on his own survival.
If this attack really was about targeting Iran’s nuclear facilities, it is far more likely to require boots on the ground…..and the latter is a whole different proposition which both Israel and the US would want to avoid. For now, it looks like they will trade a barrage of blows via airstrikes and drones.
Trump issued a statement in which he urged Iran to reach a nuclear deal “before there is nothing left”. This speaks to the point above about pressuring Iran to reach a deal. In his statement he warned “…..the US makes the best and most lethal military equipment anywhere in the world by far and that Israel has a lot of it with much more to come – and they know how to use it”. Iran will need several aces up both sleeves if it chooses to go into a long war. Suggestions that it might strike other, surrounding nations or spice things up in the Straits of Hormuz are not really going to cut it.
What of markets?
Oil prices initially surged some +13% before paring back gains to about +7.5%. This is key because recent improvements in inflation have been heavily boosted by low/falling oil prices. The passthrough effect of rising energy prices is quick and will be felt in the inflation prints in the months ahead if this situation drags on.
A reasonably quick resolution to this conflict ensures a return to “normal”. In a classic “Risk Off” environment, the US$ is rallying with the US$ Trade-weighted Index (TWI) gaining +0.60%. Normally, the US$’s gain should have been even larger in a “shock” scenario – it raises the question whether markets do not see this progressing into an all-out crisis or is this a sign the US$ is not quite the safe haven choice as once perceived. In fact, and interestingly, we’re not seeing the normally-associated jump in bond prices either. US Treasuries are down (i.e. bond yields are up) in the order of 0.01%. Normally, they would have soared.
UK Gilts (Government bonds) are getting pummelled with the 10y and 30y yields rising +0.04% and +0.03% respectively. The latter is more likely to do with the UK’s recent spending review and its fall in April GDP (see brief comments below).
It’s a similar story for bonds elsewhere with Japan being the exception (its 10y JGB is up, a normal “safe-haven” reaction). Gold is up (over +1%) and equities (including US futures) are all down. So far, the reaction by markets is not entirely what we would “normally” expect….and that’s worrying!
Finally, onto the UK. On Wednesday, the finance minister (Rachel Reeves) delivered her 2025 Spending Review. The chart below summarises the winners and losers by department:
Clearly, energy is the biggest beneficiary with average annual real growth of +15% to +16%. This is led by nuclear energy and benefits Rolls Royce who was the winning bidder for small UK nuclear reactors. Major cuts are borne by transport and the foreign office.
Overall, day-to-day net spending grows +1.7% in real terms per annum (over £40bn pa). The net increase in public spending is not fully balanced by cuts. Furthermore, breaking down the spending savings, the picture looks as follows:
- The savings are a combination of direct savings and efficiency target savings (amounting to £21bn to £25bn) pa, of which……
- …….Direct savings amount to £7bn to £10bn pa (comprising things like cuts in Official development Assistance, Foreign and Commonwealth Development Office, High Speed rail transport 2 (HS2), non-HS2, the Cabinet Office and Law Officers’ Departments but…….
- ……..Efficiency savings (all departments). These are simply targets – not actual cuts! The targets are £14bn to £15bn pa by 2028/29. This is precarious because historically, meeting such aims do not have a record of yielding a good outcome. Think of it as a kind of UK version of DOGE.
- So, the total £53bn pa new spending is not fully offset by the total meaning there is a net fiscal expansion!
- The government is trying to frame this as balanced when in fact over 70% of the offsets in spending are from targeted efficiency gains.
Market reaction was clear – they weren’t impressed or reassured:
- Bond yields increased (i.e. increases funding costs) as this higher net spending has to be financed in the gilt market. The 10y hit 4.6% to 5.2% reflecting investor caution over deficits and debt issuance.
- GDP weakened as shown by the April release which saw a big fall of -0.3% on the previous month. Five factors were in play: (1) an inevitable unwind for February’s strong (+0.7%) result which was boosted by increased orders ahead of tariff implementation, (2) a rise in tax and national insurance on businesses who have curtailed spending/investment plans, (3) a rise in domestic energy bills on consumers and (5) continuing tariff uncertainty.
- Inflation remains elevated in the 3.5% to 4.0% range and a source of concern for the Bank of England. Its easing path is proving to be a long one.
- GBP is holding at almost 3y highs vs the US$ but is overshadowed by fiscal and debt concerns. Higher yields will be required to compensate for risk but GDP looks suspect and not supportive of a strong GB£.
MARKET SUMMARY…
