Castle Securities warning: From inflation impact to economic crisis, the market is starting to price in "shrinking demand"

According to Castle Securities, the impact of the Middle East conflict on the market is entering a new phase, with investors shifting their focus from the initial inflation shock to the impact on global economic growth. Strategist Frank Flight wrote in a client report on Monday that the slowdown in economic activity and the trend of "demand contraction" could support long-term inflation-adjusted bonds. At the same time, he said that bullish options on the US dollar provide an "attractive asymmetric" protection against further escalation of the Iran situation. Earlier, US President Trump said on Monday that he would delay strikes on Iran's energy infrastructure, which stimulated stock and bond market rallies, while oil and the dollar fell. However, Flight also warned that any measures to ease tensions would not be able to reverse the "some lasting damage" to the global supply chain caused by the historical oil market turmoil described by the International Energy Agency. Flight wrote, "The market is forced to face the reality of at least partial demand contraction and the many butterfly effects of the conflict. The direction of the next stage may depend more on the extent of the economic growth shock rather than the dynamics of conflict escalation." Yield surges in March Since the outbreak of war at the end of February, bond yields in major markets have surged significantly, as investors have priced in the risk that major central banks may need to raise interest rates (or abandon easing plans) to cope with the worsening inflation caused by rising energy costs. Meanwhile, the dollar has strengthened significantly, partly due to safe-haven demand. Flight said that once short-term interest rates stabilize, as investors begin to focus on the damage caused by the conflict to economic growth, the real interest rates in the forward market (or inflation-adjusted rates) will "stabilize." The strategist said that the conflict is approaching a crossroads, with the situation potentially escalating or ceasefire but either outcome will have a negative impact on economic growth. Continued supply shocks will severely damage the already fragile global economy, with consumers already exhausting excess savings and the labor market softer than during the 2022 Russia-Ukraine war-induced energy shock period. On the other hand, if economic growth shows more resilience, major central banks may tighten monetary policy to curb inflation, ultimately putting pressure on economic activity. Flight said that developing countries, especially many energy-importing countries, are particularly vulnerable. He added that currency depreciation may force major central banks to raise interest rates, exacerbating domestic economic slowdown. Weakness in emerging market assets, in turn, could dampen global economic growth, while pushing up the dollar exchange rate, exacerbating the currency tightening cycle. Flight also warned that the market may be underestimating the scale of supply interruptions. He said that shortages are spreading from oil to liquefied natural gas, helium gas, and fertilizers, increasing the risk of comprehensive supply constraints. "We believe the market has not fully considered second-order effects and 'butterfly effects'," Flight wrote.