US strikes over the weekend are a significant escalation, and the world is watching closely for Iran’s response and impact. Markets appear relatively stable at this stage, suggesting expectations of a contained response for now. Oil’s risk premium remains elevated, and prices are up at the front of the curve, on the risk of the Straits of Hormuz being shut, albeit markets don’t seem to think sustained closure is possible (either from an economic or military perspective). From a macro perspective, the situation from here remains messy, with a complex mix of potential retaliation, military posturing, diplomacy and deterrence - and an elevated risk of a wider conflict, with no quick resolution.
Key takeaways:
- Markets remain stable, but oil prices are elevated and the potential closure of the Strait of Hormuz is a substantial risk.
- Iranian attacks on Gulf oil facilities and signs of regime instability in Iran could also add to a supply-side shock to inflation from oil.
- Investors should maintain a neutral risk stance while remaining adaptable. Diversification and flexibility in asset management, including currency positions and selective hedges like gold, are crucial.
US strikes over the weekend are a significant escalation of the conflict in the Middle East, and the world is watching closely for what Iran does next. Markets appear relatively stable, suggesting expectations of a contained response for now. Oil’s risk premium remains elevated, and prices are up at the front of the curve, owing to the possibility that the Straits of Hormuz will be closed. Nonetheless, markets don’t seem to think sustained closure is possible (either from an economic or military perspective).
The situation from here will remain messy, comprising a complex mix of potential retaliation, military posturing, diplomacy and deterrence. There is still an elevated risk of a wider conflict with no quick resolution.
Macro context: supply-side shock is primary risk
The main risk to the global macro economy is a supply-side shock through higher oil prices or, in a worst case scenario, oil shortages. Leveraging research from the Dallas Fed, we find that if oil prices in the US rose to/above US$100/bbl this would lead to headline CPI in the US rising by nearly 100 basis points (bps). Conversely, if oil prices stayed at their current level then headline inflation in the US would only rise by approximately 25bps.
The main determinant of whether or not the global macro economy is hit by an oil supply shock will be how Iran responds, and the effects of any escalatory cycle. The three risks to global oil supply that we are tracking are:
1. The closure of the Strait of Hormuz, and how long this lasts
2. Iranian attacks on other Gulf oil production facilities, and how long it takes to get these back online
3. Signs of regime collapse/fracturing - this has the potential to weaken the long term production capacity of Iran
The Strait of Hormuz is a key watchpoint given approximately 20% of the world petroleum transits through it. However, given 100% of Iran’s oil production passes via the Strait, attacks here would be very much a last resort by Iran to salvage deterrence if the conflict escalates from here.
Given the Iranian military’s weakened state, and the significant amount of US military assets that have been accumulated in and around the Middle East in recent weeks, it seems increasingly unlikely that Iran has the will or capability to deliver sustained damage to the world’s key source of petroleum product. However, given diplomatic off-ramps have yet to be activated, we would expect the elevated geopolitical risk premia currently embedded in oil markets to sustain until a sustainable resolution is found. This will further complicate the task global central bankers face in navigating what has been a bumpy disinflationary process across DM economies. Specifically, we would expect these elevated oil prices to further slow the cutting cycles of the Fed and BoE, further constraining their hands, stopping them from cutting any more than once this year.
Investment implications: staying neutral on risk but nimble approach is key
For investors, it’s important to remember what we can and can’t predict, positioning portfolios for resilience in the event that markets move sharply from here. The coming weeks hold multiple risks in markets, including US tariff and policy developments - but these are two-way risks as markets could also ‘climb the wall of worry’ once they pass. From an asset allocation perspective, we believe this is a time to stay broadly neutral risk overall – but taking more granular views within regions and asset classes, buying selectively on weakness and selling on strength at the margin. Diversification remains key, as well as the flexibility to actively manage evolving risk - including currency positions and selected hedges (for example, gold).
