Key takeaways:
- The Middle East conflict has intensified, the Strait of Hormuz is effectively closed, and new Iranian leadership has reduced prospects for near‑term de‑escalation.
- Energy supply disruptions, rising oil and gas prices, and lack of a clear off-ramp are increasing inflation risks and driving greater volatility across global markets.
- A prolonged conflict could deepen economic strain, but US political pressures mean a rapid resolution – or declared “victory” – cannot be ruled out, keeping the outlook for asset prices uncertain.
The conflict in the Middle East has escalated over the last few days and hopes for a short war have faded. Regional diplomatic efforts to de-escalate appear to be failing and Iran continues to retaliate in response to strikes from the US and Israel. As a result, the Strait of Hormuz – the world’s most important gateway for energy commodities – remains effectively closed to all but the most buccaneering of shipping companies.
The Strait closure is a result of a lack of insurance, firms not willing to risk the loss of future capacity if ships are sunk, and concerns for the welfare of sailors after several fatalities already. However, there are now risks of more intensive intervention from the US and/or Israel following reports that they are considering putting boots on the ground, either to try and extract Iranian enriched nuclear material or to take Kharg Island, a key sea terminal for Iranian oil exports. At the same time, a new Supreme Leader of Iran has been chosen who is seen as another hardliner. This is unlikely to be taken well by the US, who would have preferred someone more moderate, and the choice appears unlikely to create a path to de-escalation.
The desired end point is still uncertain
It is still not immediately clear what the ultimate objectives for the US and Israel are. Various intentions have been publicly stated but it is not clear which of these are red lines and which are just preferences. A further reduction of the potential for Iran to build nuclear weapons appears to be the closest to a requisite. However, given that strikes in 2025 were deemed to have achieved this, defining the outcome is difficult. Similarly, a desire to destroy Iran’s long-range missile program has been expressed, but this may similarly be difficult to guarantee. Finally, regime change, either for military or humanitarian reasons, is now touted as a key objective, but it remains unclear how this can be achieved with airstrikes alone.
The objective matters
Understanding the motivating objectives is important when considering how long the war might last and the subsequent economic impact. We can look to several factors that suggest this could be a more prolonged campaign. Iran has indicated that it can continue with its current rate of response for six months, far longer than the weeks-long engagement that markets appeared to have been pricing. The US has expressed that it wishes to remove the previously enriched uranium that could be used in nuclear weapons, but it has been a long time since the last international inspection and its whereabouts are likely to be very uncertain. Similarly, the continuity of a new hardline leader suggests that Iran is feeling little pressure to change tack yet.
However, there are also ways in which the conflict could be wound up sooner. The most obvious is that US President Trump has shown a willingness to abruptly change direction on policy multiple times throughout his leadership, no matter the scale of the impact. With mid-term elections coming up later in the year, the US government is likely to be highly sensitive to anything that pushes up the cost of living. Therefore, finding a way to declare victory and return oil prices to lower levels may ultimately dominate any longer-term military objectives.
The length matters
A longer-term conflict raises the danger of greater destabilisation in the region, creates greater potential for more severe damage to key infrastructure and risks longer-lasting impact on energy supplies. While there are some ways to mitigate the impact in the near term, such as sending oil through pipelines to ports outside of the Persian Gulf or by releasing strategic reserves outside of the Middle East, these are either inherently temporary or lack the potential capacity to offset prolonged restrictions in the Strait of Hormuz.
Oil is often seen as the key commodity when considering conflicts in the Middle East, given its relevance to US gasoline prices in particular, but natural gas supplies are crucial for other regions, such as Europe, and other base products feed into areas from chemicals to fertilisers. Last week, markets appeared to be pricing energy commodities in line with a short-term interruption to the ease of supply. Assumptions around this appear to have changed over the weekend, with prices now moving to incorporate greater risk of a prolonged engagement. The lack of clarity around the US/Israeli objectives does nothing to reduce the uncertainty that markets hate.
Impact on markets
The price of oil has spiked above US$100 per barrel as concerns about supplies have intensified. European natural gas prices have almost doubled since the end of February. This is raising the spectre of the inflationary impulse generated by the Russian invasion of Ukraine in early 2022 and the subsequent removal of much of the Russian supply into energy markets.
Concerns about a jump in European inflation or simply prolonged stickiness in the US are lifting bond yields. US Treasury yields have moved higher as markets have taken out one of the US Federal Reserve interest rate cuts that were anticipated by the end of the year. Yields on 10-year Treasuries have seen less movement than their European counterparts, as US jobs numbers on Friday served to offset some upward yield pressure from expected inflation.
Concerns about inflation have seen surges in German and UK breakeven rates, with market pricing for the European Central Bank interest rates at the end of 2026 now looking at over 1.5 hikes. Since the end of February, expectations for the Bank of England have shifted from two cuts by the end of 2026 to a better than 50:50 chance that there will be an interest rate hike – a marked shift in the outlook. Markets are now pricing in higher oil prices for the foreseeable future, with concerns mounting about a stagflationary outcome, should higher energy costs stall a re-acceleration in economic growth.
The uncertainty has provided support for the much-maligned US dollar, given the American economy is looking better set to weather an energy shock than elsewhere. However, higher bond yields and a stronger greenback have dampened gold’s ability to rally in the current environment, following strong performance during other recent periods of volatility.
Equity markets are seeing something of a reversal of recent performance dynamics. Markets that started the year positively, to the end of February, suddenly look under greater pressure. A stronger dollar and higher oil prices are weighing on Asian stocks that had been surging in the first two months of the year. Gas prices remain Europe’s geopolitical Achilles heel and markets are clearly concerned that the region is overly exposed again. In the US, last week saw some signs of a reversal of the recent outperformance of Value stocks over their Growth counterparts. AI-related stocks have struggled in 2026 so far compared to the rest of the market, but the fears that higher oil prices could dent the very rosy economic outlook are leading to something of a reconsideration.
The effective closure of the Strait of Hormuz is unprecedented, undoubtedly making for severe impacts on risk assets. However, to put the sell-off in proper context, investors must also recognise that equities entered the conflict trading at a meaningful premium over historical valuation levels. The forward price/earnings ratios (P/Es) of major global equity markets were at top quartile levels versus their 20-year histories, roughly a 15%-30% premium compared to median levels. Indeed, the markets experiencing the largest sell-offs are the ones that entered the conflict with the highest returns year to date (to 9 March 2026).
Risks of a prolonged war but don’t rule out a quick “victory”
Situations like this demonstrate the value of well-diversified multi-asset portfolios. Geopolitical events are rarely easy to gain complete clarity on, with the current US administration apparently embracing uncertainty as a negotiation strategy. What we can take away from the events of the last few days is that it is likely the conflict could last longer than many had initially hoped. This means there is the potential for greater economic impact – and markets have moved to price in this change.
There is the potential for faster inflation and slower economic growth, with assets focusing on different aspects thus far. However, risks remain two-sided. US political pressures means that a quick “victory” should not be ruled out. Asset prices, driven by energy prices, are likely to swing violently as investors alter their expectations for either outcome.
Glossary:
Breakeven rates: A market-based measure of expected inflation, calculated as the difference between the yield on a nominal bond (like a 10-year Treasury) and the real yield on an inflation-indexed bond (like TIPS) of the same maturity. It represents the rate at which an investor earns the same return from both bonds.
Growth stocks: Growth investors search for companies they believe have strong growth potential. Their earnings are expected to grow at an above-average rate compared to the rest of the market, and therefore there is an expectation that their share prices will increase in value.
Inflation: The rate at which the prices of goods and services are rising in an economy. The consumer price index (CPI) and retail price index (RPI) are two common measures.
Price/earnings (P/E) ratio: A popular ratio used to value a company's shares compared to other stocks or a benchmark index. It is calculated by dividing the current share price by its earnings per share.
Treasuries/US Treasury securities: Debt obligations issued by the US government. With government bonds, the investor is a creditor of the government. Treasury bills and US government bonds are guaranteed by the full faith and credit of the US government. They are generally considered to be free of credit risk and typically carry lower yields than other securities.
Value stocks: Value investors search for companies that they believe are undervalued by the market, and therefore expect their share price to increase.
Volatility: The rate and extent at which the price of a portfolio, security, or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. The higher the volatility, the higher the risk of the investment.
Yields: The level of income on a security over a set period, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the coupon payment divided by the current bond price.
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