Cam Harvey: The Seven Risks of the Iran War

- I'd like to welcome everyone back to another episode of Cam Harvey's "Through the Noise," and let's just get right into it. This week, I think everyone has been paying attention to what is going on in Iran. Certainly, the markets have been paying attention, they've been up, they've been down, down mostly. And yet we live in a world that has conflicts all over the place, and we've lived with a world with conflicts as far as I can remember. So why are we paying so much attention to the war in Iran? - Well, obviously, we're paying attention because we're at war, but I think it's really important to realize that every war is different, every crisis is different. And there are certain categories that we could use to try to think about the implications. And one useful way to categorize is just how local the conflict actually is. So, think about the war in Afghanistan, that was local. It wasn't disrupting the world economy in any way, maybe it disrupted poppy production. And contrast that with Iran, which is much more connected with the rest of the world, so we've got global implications. So I think that is a key difference, and that's certainly why markets are taking this war much more seriously than, for example, what happened in Afghanistan. - Okay, do you have any examples of the kind of risks? Why in particular is Iran so well-positioned to be a big player in the world economy? - Yeah so, I think of kind of a categorization of different uncertainties that exist here. So, let me go through some ideas, some of which are obvious, as to why this is very important for the world economy and for financial markets. So, number one. One uncertainty is the risk that inflation is rekindled. So 20% of the world's oil goes through the Strait of Hormuz, and that's stopped right now. That's the reason that the price of oil has spiked. And inflation is very important in terms of the economy, it's also very important politically, so higher inflation is bad news. So even though the U. S. is relatively self-sufficient in oil, that doesn't mean that the prices remain the same. It's a global commodity, so prices actually go up. So, number two, this particular area of the world is economically important, not just for oil, so this is a cluster of important countries in this area. And again, I contrast this with Afghanistan, which was local, even Vietnam, even though that was a long and painful war, it was relatively isolated, not a major player in terms of world trade. So just having a cluster of important countries in this area has negative implications. Number three, there's uncertainty about China. So, China's not involved in this directly, but could they be indirectly? And in particular, does the U. S. operating in this theater in the Middle East create an opportunity for China to expand territorially, knowing that it would be very difficult for the U. S. to fight in two theaters? So number four, in terms of uncertainty, is the length of the war. So markets like short, surgical sort of strikes, a short war. The example of the 12-day strike previously on Iran is an exemplar for that. So any uncertainty about the length is really a big deal. So if the expectations move to a longer war, then that is negative news for the market. Number five uncertainty has to do with regime change. So the previous regime is gone, and there's uncertainty about the new regime, so it is possible that the new regime creates more problems than the previous regime. So that's yet another level of uncertainty.

Number six is in the background, it's not well-discussed, but I want to put it on the table, and that is, is the U. S. in a financial position to conduct a longer term conflict? The U. S. has a $38 trillion debt. The fiscal deficit is $1. 9 trillion a year. That is not a position of strength, and we know that war is expensive. So a shorter term war is much preferred, because it's cheaper, but if this goes longer, that creates strain on the financial health of the U. S., which already is burdened with a very significant debt, more than the GDP of the U. S. And I guess the last piece of uncertainty is subtle but important. This is not the U. S. 's first expedition to the Middle East, and there are questions as to whether the U. S. has learned the lessons of previous engagements in the Middle East, and I think that also creates some risk. - Okay so, (laughs) this is like a nesting doll of risks, we just go layer, by layer, by layer, and the markets are reacting. But how certain are people about these risks? - Okay, I like this. So really, what you're talking about is something I've thought deeply about, and this is the idea of the uncertainty of uncertainty. So let me unpack that just a little bit. So you might have a measure of risk, and it goes from 0 to 100, where zero is like no risk, nirvana, and 100 is thermonuclear war. So you might have a measure, let's say it's 65, and you're pretty confident about that. So maybe it's 67, maybe it's 63, it's in a narrow range. But in another scenario, you might be less certain about what the risks actually are. So, maybe it's 65, but it could spike to 90. And I think this particular conflict is like that. So imagine how risk would explode if China uses this to their advantage. So there's a lot of uncertainty or ambiguity about the risk, and, of course, financial markets do not like risk. So when risk spikes, that means that there's less investment, so companies hold off on major projects until the uncertainty is resolved. And investment is a driver of GDP growth, so that negatively impacts the cash flows of companies, and especially so if this is the longer term conflict. And risk also affects the time value of money. So, we value stocks and other assets in terms of the value today of those future cash flows. And if risk increases, then the risk premium will increase, people demand a higher rate of return, and the only way that they can get that is if asset prices drop. And if there is a spike in risk, that drop could be a plummet. So it's really important to take the risk into account, and, as I also mentioned, just the uncertainty about the uncertainty. - Well, thank you so much for these thoughts that are really pertinent today, and also tied to things you've been thinking about for a long time. Thank you very much. - Thank you.