Fears of an escalation in the conflict between the US and Iran, or, more precisely, between Israel and Iran these days, abated by yesterday afternoon, following a $5 rally earlier in the day. Reciprocal strikes between the arch enemies over the weekend were followed by a tentative cessation of hostilities, accompanied by an explicit and ominous warning from the Israeli Prime Minister that the struggle against Iran and its proxy in Lebanon was “not finished.”

The sell off from yesterday’s peak continues this morning, further pressured by plunging Chinese crude oil imports, which fell to an eight year low last month. Clearly, headline driven trading prevails, and confidence in the imminent reopening of the Strait of Hormuz has been restored. According to the US President, a peace deal with Iran is “very close,” (again), and the pivotal waterway could reopen in “two or three days,” (again).

Meanwhile, the exodus from AI stocks in the second half of the week proved to be a nasty, sharp, but brief downside correction, and nothing more. Anxiety about resurgent inflationary pressures and fears of central bank rate increases have not abated; yet the belief that the tech sector is more than capable of neutralising the economic headwinds precipitated by the Iranian conflict remains intact, a conviction only strengthened by OpenAI’s confidential filing for an IPO.

What Does It Take to Defeat Iran?

Last Sunday marked the 100th day of the Iranian conflict, which has its origins in the callous Hamas attack on Israeli civilians on 7 October 2023. There is, at times, a heated debate about whether the response, swift and forceful from the outset, has been proportionate. But there is no denying that the Israeli leadership also used the unforgivable assault on its citizens as a deflection from domestic political predicaments, such as corruption allegations and efforts to limit the power of the judiciary. Benjamin Netanyahu, it appears, pulled off a political masterstroke when he convinced the US President to lend unprecedented support in pursuit of his ultimate objective: the obliteration of the Iranian regime.

The move has gone horribly wrong; or so the last 101 days suggest. Whatever rhetoric emerges from Washington, D.C., or Tehran, the end of the current conflict is nowhere in sight. The fact that it has lasted for more than three months gives the oppressive Iranian regime renewed confidence to continue as long as its ultimate goal, most plausibly its own survival, is secured. As with the Russian Ukrainian war, the current Middle Eastern conflict appears to be a significant miscalculation in terms of both its longevity and its consequences.

Although equities, chiefly supported by the insatiable appetite for AI stocks, are holding up reasonably well (despite the recent dip in sentiment), bond prices are not. And with oil remaining at elevated levels, albeit below the April peaks, inflationary pressures are unlikely to subside. The more protracted the conflict becomes, the more severe the economic damage will be. The question, therefore, must be asked: under what circumstances might the warring parties reach a firm, sustainable, and permanent solution that ends hostilities, restores trade flows through the pivotal Strait of Hormuz, and alleviates inflationary pressure?

Common sense dictates that a diplomatic solution, i.e., a negotiated settlement, might prove the most effective and least harmful path. If the accomplishments of the Obama administration are any indication, it is reasonable to conclude that Iran’s leadership has shown a willingness to accept compromises, including significantly scaling back its nuclear programme. In the current chapter of the long history of Middle Eastern wars, such a settlement would likely involve security guarantees, sanctions relief, and perhaps even reparations in exchange for reopening the Strait of Hormuz. However, this would make Donald Trump appear weak, incompetent, and untrustworthy, as none of his major pledges, removing the Iranian regime, degrading its military arsenal, and obliterating its nuclear capabilities, would be fulfilled.

International diplomatic isolation is another possibility. This scenario assumes that the continuation of the conflict would impose an unbearable financial burden on Iran. Simultaneously, concerted international pressure from the US, the UN, the EU, and regional powers to demand mutually acceptable ceasefire terms could push the regime toward substantive negotiations. At the same time, targeted sanctions on the military and the Iranian Revolutionary Guard Corps, designed to weaken the war machine without harming civilians, could be implemented. This is a tenable scenario, but the gap between the parties is so wide that any agreement would likely take months to conclude.

Economic exhaustion is another tool available to the international community. The country’s greatest vulnerability is its oil industry. Renewed or intensified sanctions, however, would drive oil prices higher again, reigniting inflationary pressures ahead of the US midterm elections. Moreover, as noted in a study by the Center on Global Energy Policy, Iran is reasonably well equipped to withstand production shutdowns and constraints on its oil export capabilities.

From this vantage point, an amicable outcome appears highly unlikely in the near future. Yet the winds of foreign policy can shift quickly. Wars usually end not because one side is conclusively defeated, but because the adversaries realise that continuing to fight is too costly, that a military victory is unattainable, and that a negotiated outcome is preferable. As neither party seems capable of declaring a decisive victory, a combination of all the above, negotiated settlement, economic and military pressure, and diplomatic mediation, will most likely bring the conflict to an end. Neither side should claim triumph, but both inevitably will. And given that there was no political or economic justification for the conflict in the first place, this is the best outcome one can hope for.

Will such an ostensible agreement be preceded by another spike in oil prices? Since an agreement is anything but imminent, notwithstanding the sanguine US narrative, we believe so.

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