The global economy survived the Ukraine war, but can it ease the Israeli war?

India’s stock market index has lost nearly 5% in the past six days as global markets also jitter over the possible consequences of the Israel-Hamas war. Emerging market stock indexes had already weakened for about 12 weeks before the Hamas attack as weakness in the global economy appeared to persist.

A perfect storm is brewing as crude prices tighten and the U.S. dollar strengthens on the back of 10-year bond yields, which touched 5%, last seen in 2007 before the global financial crisis. Higher bond yields imply higher inflation expectations. Against this backdrop, the Federal Reserve is unlikely to pause the interest rate hike cycle anytime soon. The Reserve Bank of India has also indicated that inflation needs to be watched more carefully following the Hamas-Israel war and its potential spillover into the wider West Asian region. This is not good news for ruling regimes around the world as they approach general elections.

Markets will not take kindly to Israel’s hyper-belligerence towards UN Secretary-General Antonio Guterres, who has been pushing for adherence to international law and the rules of war. Markets are psychologically affected by the words used by global leaders.

In Ukraine, 9,600 civilians were killed in 18 months. More than 7,000 civilians have already died in Gaza in a few weeks in the most devastating bombing in a short period of time.

For example, US President Joe Biden’s advice to Israel to avoid provocation in his response may have jittered the markets. If Israel continues to act aggressively in the next few weeks, we could see another round of increases in inflation and interest rates globally, sharpening the rift between Western powers and the Iran-Russia-China axis.

Some prominent Wall Street analysts have made the contrarian argument that markets are taking the Israel-Hamas war in their stride, and that there is some hope that it will not spill over into the larger region. This belief flows from the way the Russia-Ukraine war avoided dire economic consequences because the countries were pitted against each other and decided to minimize the damage by allowing Russian oil to enter markets through the backdoor. There was certainly an economic downturn in terms of severe inflation and interest rates, but the worst-case scenario was avoided.

A similar cycle is expected to play out during the protracted Israeli-Palestinian conflict. It is true that powerful political-business elites in the United States, Europe, China, Russia, Saudi Arabia, Iran, and Israel are heavily invested in global financial assets, and their instinct is to minimize economic damage. But as President Biden has observed, any response characterized by rage and vindictiveness will upset such rational calculations. Collective market intelligence also knows this well. Things can easily spiral out of control in a war that increasingly becomes part of a rivalry between great powers. Such accidents happen in history. Hence the continued tension seen in the behavior of stocks, bonds, crude and gold, all of which will have a profound impact on the real economy. India will not be isolated from this. A lot of foreign corporate money has flown out of the Indian stock market in the past few weeks. Foreign equity money is leaving most emerging markets in search of safer investment options. US bonds are considered to offer good risk-free returns.

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Foreign direct investment (FDI) in India has also come down significantly as events like Ukraine and Gaza urge global investors to pull back until there is clarity on what lies ahead. India’s foreign trade – both imports and exports – fell sharply last quarter, reflecting shrinking economic activity. Imports and exports together account for nearly 50% of India’s GDP. Prime Minister Modi and his economic policy advisers hoped that private sector investment would finally pick up in new corporate investments after a nine-year drought. But negative global events — first in Ukraine and now in West Asia — seem to have spoken otherwise about the possibility of any meaningful recovery in the global economy. India may also witness a holding activity in the coming months as the nation gears up for the 2024 Lok Sabha elections.

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