Escalation in the Middle East: how will it affect the economy?

The Israeli attack on the Iranian consulate in Damascus (Syria) on April 1 and Iran's response 12 days later have caused an increase in tensions in the Middle East, where the situation was already particularly complicated following Hamas’ October 7 attack on Israel and the resulting impact on the Palestinian population.

At present, the conflict is in an “uncertain” stage, where any miscalculation could lead to “significant escalation.” “Calls for diplomacy and negotiation are more crucial than ever, in the hope of avoiding a wider conflict that could have disastrous consequences for the region and beyond. The next steps will depend largely on the reactions and diplomatic strategies of the main international and regional players,” indicates Gonzalo de Cadenas Santiago, General Manager of MAPFRE Economics.

MAPFRE Economics was already contemplating a possible escalation of tensions in the area due to Israel's attacks on the Gaza Strip and the conflict in the Red Sea, the main impact of which is on the price of oil. Although this time, shifts in the market have been more restrained, crude oil usually benefits and reacts upwardly when there are conflicts in this region due to uncertainty regarding the supply of this commodity.

“The escalation in the conflict has led to an increase in the war risk premium on financial markets. Investors are concerned about the possibility of an all-out war, which could have significant economic repercussions, especially in the energy and defense sectors,” emphasizes de Cadenas Santiago.

Ricardo González, Director of Analysis, Sectorial Research and Regulation at MAPFRE Economics, points out that, “so far, the financial markets appear to have had a limited reaction”, with a slight increase in bond yields that has also been influenced by the messages from the central banks last week.

In the commodities market, the barrel of Brent crude oil, the benchmark in Europe, has been trading higher since March 27 and currently stands at around 90 dollars, while the barrel of WTI crude oil, the benchmark in the United States, is at 85 dollars. These prices are still far from the most risky scenario contemplated by MAPFRE Economic Research, which anticipates the possibility of the barrel shooting up to 120 dollars, and subsequently stabilizing at around 90 dollars.

In turn, the increase in oil prices would impact inflation and erode consumers' purchasing power and, as a result, their spending. This upturn in inflation could also have an impact on the roadmap of central banks, which, given the rise in prices, might keep interest rates higher for a longer period, instead of starting to lower them this year.

Gold, in its role as a safe haven asset, would also react upward, given that many investors prefer to have their money in this precious metal than in other riskier and more volatile assets, such as the stock market. With this in mind, this commodity has moved progressively upward since March 27, from around 2,170 dollars to the nearly 2,400 dollars at which it currently trades.

How will it affect the insurance industry?

For the insurance sector, the impact of a more complicated geopolitical scenario may be seen mostly in a rebound in inflation and in insurers' portfolios, González adds.

It is on the inflation side where there could be a greater impact on the sector, should the situation trigger an increase in the price of oil or cause further disruptions in the supply chain. An increase in prices would hit the bottom line of an insurance industry that is still recovering from the inflationary cycle of recent years, especially in lines of business such as motors.

If prices were to spiral out of control again, the monetary policy decisions of the European Central Bank (ECB) and economic activity itself could be affected. However, this scenario has not yet come to pass and is not likely to occur as long as there is no further escalation, MAPFRE Economics believes.

What can we expect from the powers involved?

The attacks of recent days have further increased tensions in the Middle East. Against this backdrop, the deputy general manager of MAPFRE Economics explains that, despite not using its most powerful weapons, the consulate attack could be seen as “a signal to avoid further escalation.” However, this also exposes Iran to a potentially harsh response from Israel and its allies.

“Israel’s reaction is going to be critical. Although the military response may be measured, the country cannot afford to ignore this attack. The operation has also served to divert attention from other internal problems, such as the conflict in Gaza,” he adds. The escalation also poses a difficult situation for the United States and its allies, and they are likely to “press for a peaceful resolution” while supporting Israel's right to defend itself.

However, the different powers have not adopted the same stance in this regard. The European Union (EU) is divided, with some members advocating a ceasefire and others supporting Israel's right to defend itself. Russia, in turn, has kept up a diplomatic balancing act, without clearly leaning towards either side, and the United States is continuing its traditional support for Israel, strengthening this relationship through military and diplomatic aid.

China seeks regional stability by promoting peace, without becoming deeply involved in the conflict, and Saudi Arabia “is navigating between its historical criticism of Israel and a more moderate approach” given recent geopolitical changes and the possibility of normalizing relations, explains de Cadenas Santiago.