We can debate the reasoning behind President Trump’s decision to bombard Iran, we can speculate about what he hopes to achieve (perhaps extraction rights to Iran’s oil reserves or simply a diversion from flagging popularity numbers at home) and we can contemplate various possible timeframes for, and outcomes of, ‘Operation Epic Fury’. From an analytical perspective, however, this is unedifying. At this stage, there can be little more than conjecture about such key questions as how long the conflict might endure, the extent to which it might spill across the Middle East more widely and what shape a new Iranian leadership might take.
While there are undoubtedly more fundamental questions to answer in the midst of an escalating conflict, our job is to consider the implications for financial markets and to ask how investors should best respond.
Unsurprisingly, energy prices have lurched higher in recent weeks, initially in anticipation of the confrontation, latterly in response to its region-wide impact. Beyond Iran, the world’s largest LNG plant in Qatar has been shut down, as has a key Saudi Arabian oil refinery. The Trump administration has touted US military escorts for tankers through the Strait of Hormuz – the narrow passage of water through which 20% of the world’s energy supply flows – but it is unclear whether this is enough to ameliorate the concerns of the shipping and insurance industries. Brent crude oil has risen from $61 per barrel at the start of the year to $84 at the time of writing, its highest in 19 months. Natural gas prices have risen more sharply, particularly in Europe, where the benchmark is 70% higher year -to-date (though it remains far below the peaks reached in the aftermath of Russia’s invasion of Ukraine).
High energy prices have two significant potential implications. Firstly, they raise the hurdle for economic growth. This is a particular issue for Europe, where high energy prices place the continent’s manufacturers at a competitive disadvantage. Secondly, they raise prices across numerous supply chains and heavily influence consumer’s inflation expectations, which can become self-fulfilling.
Financial markets have initially appeared more focused on the inflationary risks than the consequences for growth. Movements in the markets for nominal and inflation-protected US Treasuries imply that investors are demanding more compensation for the threat of a near-term inflationary spike. Importantly, expectations that the US Federal Reserve may have to postpone widely anticipated interest rate cuts have prevented sovereign bonds from fulfilling their traditional ‘safe haven’ role, with yields rising and prices falling for both shorter and longer dated bonds.
The inflationary threat is ill-timed. Australia – an economy which tends to be among the first to reflect shifts in the global economic cycle – has recently been forced to raise interest rates to dampen reaccelerating inflation. Meanwhile, recent inflation data in Europe, the UK and the US have surprised to the upside. The degree to which events in the Middle East exacerbate these pressures is, to a large extent, dependent on how long the conflict lasts.
Thus far, markets seem relatively confident that, as with previous shocks emanating from the Trump administration, the disruption will prove short-lived – perhaps a couple of weeks, or months at most. We have no insight here. However, it strikes us that the line between confidence and complacency is particularly thin when the range of plausible outcomes is so wide.
We are therefore taking careful note of some intriguing market movements, albeit remaining ever wary of reading too much into short-term volatility. Though a degree of calm has been restored today, European equity markets fell between 3% and 4% on Tuesday before recovering some of the ground lost yesterday: the risks to growth clearly cannot be ignored entirely. Meanwhile gold – often held out as the paragon of inflation proofing – dropped 5% on Tuesday: to quote Howard Marks again (in a different context this time) “there is no investment idea that is so good it can’t be spoiled by too high an entry price”. The risks of the speculative excess that we believe have infected gold have also been on display in South Korea, where the benchmark Kospi index – having previously risen 163% since the end of 2024 – plummeted 20% in two days earlier in the week.
Elsewhere, pressure continues to mount in the private credit market where evidence of inadequate underwriting standards and capital misallocation continues to accrue. Indeed, luminaries such as JPMorgan’s Jamie Dimon have warned of behaviour among lenders that is reminiscent of the build up to the Great Financial Crisis.
We have little to add to the prognostications of journalists, commentators and strategists debating what the future holds for Iran and the Middle East more broadly. We limit ourselves to the somewhat bland observation that, from an economic perspective – setting aside the inevitable humanitarian consequences – the impact on growth and inflation are likely to increase the longer the conflict endures.
However, we argue that the risks currently facing investors are not purely economic. Markets seem confident that, as has been the case with so many dramatic headlines over the past year or so, ‘this too shall pass’. Consequently, we would not be surprised if waves of investors emerge once more to ‘buy the dip’. Nonetheless, for those willing to look, we believe the fraying of the equity bull market is evident in the price dynamics of financial assets that are not easily explained by the risks emanating from Iran. When valuations, expectations and speculative activity are as elevated as they currently appear, it does not take much – certainly not a war – to reveal the scale of the potential downside.
How best should investors respond to this week’s events? This, at least, is an easy question for us to answer: with great caution.
