Testing the resilience of the global economy

The ongoing conflict in the Middle East could have long-term implications for the global economy, putting upward pressure on inflation and weighing on growth outlooks.

The Organization for Economic Co-operation and Development (OECD) reports that, while the breadth and duration of the conflict are uncertain, the economic impact will shake major economies this year. Growth forecasts have been revised down due to the war in Iran, according to the OECD interim outlook. The UK has received the most severe downgrade of any G20 country and is now expected to see economic expansion of just 0.7% in 2026, down 0.5% from the 1.3% estimate in December.

The UK imports almost 48% of its total energy supply and has already felt the impact of the largest supply disruption in the history of the global oil market. The RAC Foundation, a transport policy and research organization, says that motorists have paid an additional £307 million for petrol and diesel since the Strait of Hormuz was closed. Higher energy and fertiliser prices are also expected to add to inflationary pressures. Headline inflation in the G20 is now projected to rise from 3.4% in 2025 to 4% in 2026, before moderating to 2.7% in 2027. 

Damian McIntyre, Head of the Multi-Asset Solutions Team, says the outlook favors certain asset classes. “A prolonged war is more likely to lead to a stagflationary environment, with slowing growth and elevated inflation. That could favor strength in real assets, which typically perform well under inflation. A rapid growth scenario is more difficult to foresee at present due to the war and the many ways it chokes off access to key inputs. Still, booming artificial intelligence development remains one potential source of solid growth in the months ahead.”

While the OECD appears relatively sanguine on the prospect of interest rate hikes — assuming many economies raise rates between 25-50 basis points in a downside scenario — markets are pricing in more aggressive action from central banks. 

Major economies have seen a pronounced jump in short-term yields since the war started. Yields on two-year government debt across developed markets have shot up since the US and Israel attacked Iran in late February.

Mitch Reznick, Group Head of Fixed Income – London at Federated Hermes Limited says markets are now expecting as many as three rate hikes from the Bank of England (BoE) and the European Central Bank (ECB) and one from the US Federal Reserve (Fed) by year-end. “This is a remarkable turn of events in just a matter of weeks. The sell-off at the front end of the curve has caused dramatic bear flattening, accelerating the twist in rates curves. In the space of just over a month, we have seen more than 85 basis points of flattening in the two-year/30-year gilt curve from peak to trough, and dramatic flattening in others as well,” he says.

“Concerns about inflation and, as a consequence, central bank rate activity appear to have eclipsed worries about the effects of rising geopolitical risks stemming from the US/Israel conflict with Iran,” Reznick says, adding that it speaks volumes about the market’s belief that the current conflict can be contained and that elevated oil prices in the near term appear likely.”

“However, the extent to which containment is possible beyond the oil price remains an open question. What is clear is that rates markets have made a rapid U-turn from the dovish, consensus-led rally this year (until March 2). This suggests that markets now see central banks lifting rates to tame inflation, which, in turn, has caused pronounced moves in credit markets,” he says.

The BoE elected to hold rates at 3.75% in March. The Fed kept the target range at 3.50% to 3.75% last month. The ECB held the key deposit rate at 2% in March.