War is expensive and inflationary.

The economic impact of the war that began with the surprise terror attack by Hamas on Israel will turn on many questions that cannot be confidently answered at this point. How long will the retaliatory Israeli siege on the Gaza strip last? Will war have significant spillover geopolitical effects, perhaps impacting relations between Israel and Saudi Arabia or between the U.S. and Saudi Arabia? Will global oil supplies be constrained by tightening enforcement of Iran sanctions or further production cuts by OPEC+?

"As it has been reported, this is not the typical Hamas-Israel scuffle, but something potentially larger that could have implications on the war in Ukraine and the proposed deal between Israel and Saudi Arabia. The conflict could also potentially raise tensions between Israel and others in the region if more information surfaces regarding their potential involvement in the attack," analysts at Bank of America pointed out in a client note on Monday.

Importantly, this is not an isolated event. Rather it should be viewed in the context of the Russian invasion of Ukraine. It is the second major attack on a U.S. ally in the past two years. It raises the prospect that the future holds more military conflict than the recent past.

It is widely agreed that Russia's invasion of Ukraine had an inflationary effect, primarily through the channels of energy and food supplies. In an era in which disinflationary forces were stronger, the Ukraine war shock could likely have been readily absorbed without increasing prices too much. Coming in an already inflationary environment, however, the supply shock was likely amplified.

Oil and War Stocks Jump

Oil prices moved sharply higher on Monday, implying at least some concern among traders that supplies could be constrained in the near future even if there is no immediate impact on global oil production. U.S. stocks tumbled as investors were confronted with yet another source of uncertainty about global economic developments.

Of course, the war will have a profound impact on the economy of Israel, the West Bank, and Gaza. Geographically neighboring economies and those closely tied to Israel are also likely to experience "collateral damage." Studies suggest that wars tend to trigger higher rates of inflation in countries in close proximity to military conflict.

Israel's economy is the 28th largest in the world, according to the World Bank. It is 43rd in terms of imports, according to the International Trade Centre, and 36th in terms of exports. Its major exports are high-tech equipment, pharmaceuticals, and cut diamonds. Imports include petroleum, autos, and diamonds. The U.S. is Israel's largest trading partner, with $50.6 billion of goods and services crossing between the two countries. Exports from Israel to the U.S. were $20.0 billion in 2022 and imports were $30.6 billion, according to Office of the United States Trade Representative.

Apart from the impact on oil prices, the war triggered big jumps in the prices of U.S. makers of war machines or "defense stocks" as they are more politely called. Shares of Northrop Grumman rose by more than 11 percent on Monday. Raytheon shares were up 4.3 percent. General Dynamics shares rose 8.5 percent. Lockheed Martin shares climbed 8.2 percent. Shares of Palantir were up by around 5.4 percent.

Traders in these stocks appear to be anticipating the possibility that the conflict will trigger more spending on military equipment.

"This may force the US government to increase investment in the defense industrial base to build munitions and weapon systems at faster rates and in higher volumes. Ultimately, the US will be supplying munitions, missiles, and anti-missile systems to two allies (Ukraine and Israel) on top of supplying its own needs," Bank of America's analysts wrote. "As in any resource-constrained environment, difficult choices may have to be made as to who gets what from Pentagon inventories. Further, the potential strain on the US defense industrial base could embolden global bad actors."

Keep in mind that orders for military goods produced by U.S. manufacturers are already elevated. Year-to-date, new orders for defense capital goods in August were up 15.6 percent compared with the first eight months of 2022. Orders for defense aircraft were up 13.0 percent.