Stupid, it’s the economy.

James Carville, Bill Clinton’s political advisor famously said that when it came to elections it was the economy, stupid. This year’s presidential election is likely to prove no exception. Six months before that election, a constellation of economic risks is building both at home and abroad that could shake markets and cause another inflation spike. It could also precipitate a financial crisis as occurred on the eve of the 2008 election with the Lehman bankruptcy.

Last week’s unprecedented and massive Iranian missile and drone attack on Israel underlines the risk that the Middle East conflict could widen in the run up to the presidential election. The war with Gaza is far from over and Hezbollah, an Iranian proxy, keeps firing rockets at Israel. A broader Middle East war could reverse the progress made to date in reducing inflation from its 2022 multi-decade high and make inflation a principal focus of the election.

In its fight against inflation, the last thing that the Federal Reserve needs is an oil price shock that would result from the disruption of oil flowing through the Straits of Hormuz. With around 20 percent of the world’s oil supply flowing through those straits, it is difficult to overestimate their importance. The Fed’s task of bringing inflation to heel would be further complicated if escalation in the Houthi’s activities in the Red Sea resulted in a supply chain disruption that could disrupt the flow of trade through the Suez Canal.

Even before the latest ratcheting up of Israel-Iranian tensions, Fed Chair Jerome Powell warned that progress in fighting inflation had stalled. In his view, this made it necessary for the Fed to keep interest rates higher for longer and to not start cutting rates until there were clear indications that inflation was coming down to the Fed’s two percent target on a sustainable basis. The market has taken note. It is no longer pricing in interest rate cuts this year and it has sent the 10-year Treasury rate back over 4.5 percent.

High interest rates for longer are bound to deepen the commercial property crisis. With office vacancy rates at record levels, it is difficult to see how property developers are going to be able to roll over the $900 billion in property loans that mature this year. This would especially seem to be the case with interest rates at least five percentage points higher than those at which the loans were already contracted. Highlighting the risk that the commercial property crisis will come to a head before the election is the fact that office prices are plunging and commercial property foreclosures are already running at around twice last year’s pace.

Early last year, the Silicon Valley Bank failure caused markets to shudder and required large-scale intervention by the Fed and the Federal Deposit Insurance Corporation to forestall a full-blown banking sector crisis. In the run up to the election, there is now the all too real risk that we will see a wave of regional bank failures that could again shake the financial markets. It is not only that the regional banks have devoted a large part of their loan portfolio to commercial property lending. It is that these banks are nursing very large mark to market losses on their balance sheets due to a large interest related fall in the value of their bond holdings. A recent National Bureau of Economic Research Study suggests that almost 400 small and medium-sized banks could fail over the next year or two.

Souring US and European trade relations cast another dark cloud over the US and world economies in the run up to the US presidential election. At the heart of the problem is China’s attempt to export its way out of its manufacturing overcapacity caused by the bursting of its housing and credit market bubble. The outbreak of a trade war with China would add to world inflationary pressures and contribute to market turbulence.

All of this would suggest that the US economy and market sentiment could be very different than they are today. This could make inflation and the economy a principal focus of the election.

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