Overview
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 main concern
Drawing on research from the Dallas Fed, we find that if oil prices in the US rose to or above $100 per barrel, the country’s headline CPI would rise by nearly 100 basis points. But if oil prices stayed at their current level, then headline inflation in the US would only rise by approximately 25bps.
Iran’s response - and the effects of any escalatory cycle - will determine whether the global economy is hit by an oil supply shock. We are tracking three related risks:
1. The closure of the Strait of Hormuz, and how long it 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 critical: around 20 per cent of the world’s petroleum passes through it. However, given all of Iran’s oil production passes via the Strait, attacks here would be very much a last resort for the country.
There is no sign as yet of a diplomatic off-ramp and the current elevated geopolitical risk premium will remain embedded in oil markets until a sustainable resolution is found. This will further complicate the task central bankers face in navigating what has been a bumpy disinflationary process across developed market economies. Specifically, we would expect these higher oil prices to further slow the rate cycles of the US Federal Reserve and the Bank of England, and prevent them from cutting more than once this year.
Investment implications: stay neutral on risk but be nimble
For investors, it’s important to remember what we can and can’t predict, and to position portfolios for resilience in the event that markets move sharply from here. The coming weeks hold multiple risks for markets, including US tariff and policy developments - but these are two-way as markets could also ‘climb the wall of worry’ once they pass.
From an asset allocation perspective, this is a time to stay broadly neutral on risk while 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).
