War in Iran: Frequently Asked Questions

Conflict in the Middle East erupted on February 28th after U.S. and Israeli attacks on Iran killed the country's Supreme Leader Ayatollah Khamenei. The conflict has since widened to other Gulf states, rattling markets and driving up oil prices. Below, we address some of the most frequent questions we're hearing from investors.

Investors should avoid overreacting. Geopolitical shocks and crises rarely result in major sustained impacts to global economic growth or financial markets. Moments like this tend to produce an incredible amount of noise and spectacular headlines that often focus on worst-case outcomes. Making reactive changes to strategic portfolio allocations during fast-moving geopolitical events can lead to adverse impacts. Indeed, strategically constructed, diversified portfolios are built to weather periodic geopolitical shocks such as this one. Likewise, given the degree of uncertainty, now is not the time to aggressively add to risk.

Rather than attempting to guess what comes next, we believe assessing a range of potential outcomes is most prudent. The scenario analysis we share here is focused on how global energy supplies may be disrupted and how long that impact may last. The table below lays out three scenarios—an upside case, a moderate case, and a downside case—and depicts potential impacts on economic growth and financial markets.

• The upside case is defined by a quick end to military operations where energy production, shipments, and pricing quickly return to pre-conflict levels.
• The moderate case sees military operations continuing, albeit at reduced intensity, with a gradual end to the conflict. Oil prices remain elevated, but there is no major disruption to global supplies.
• The downside case sees a prolonged conflict whereby military operations continue and global energy supplies are disrupted resulting in oil prices spiking to levels that have negative impacts to global growth and inflation.

For global economic conditions and financial markets, global energy production and shipments are the key issues. Traffic through the Strait of Hormuz between the Persian Gulf and the Gulf of Oman carries roughly 20% of world oil supply. We have already seen severe disruptions given threats of attack from Iran and insurance companies substantially increasing premiums or may refusing coverage. U.S. President Donald Trump's offer of risk insurance and escorts of tankers through the Strait of Hormuz may or may not be enough to see a resumption of shipping. The U.S. International Development Finance Corporation would need some creative operational changes to replace private insurance and even then, concerns about the crew safety may limit the willingness of shippers to take the risk of passage. An end to military operations will likely be needed for a return to normal.

A rapid end to the conflict or even a gradual reduction of hostilities may be enough to avoid sustained impacts to global growth and inflation. In these cases, policymakers are likely to remain on the sidelines, waiting to gauge how the conflict plays out and to what degree economic and financial conditions are impacted.

The risk of recession increases the longer energy supplies are disrupted, with larger impacts on Europe and Asia-Pacific. Oil and natural gas importers, including Europe, Japan and emerging Asian countries are the most impacted by rising oil and gas prices. However, energy accounts for a smaller share of consumption baskets than in prior decades and because many central banks are committed to price stability, the risk of a sharp and persistent rise in inflation is likely limited. This is particularly the case in the U.S. where domestic oil production has left the country in a net export position. Moreover, the Energy sector currently makes up just 2.5% of the S&P 500, so any impact to global production would tend to have limited direct impact on aggregate equity market earnings.

In the downside-case scenario, Europe and Asia would most likely face recession due to disruption of energy supplies leading to a rapid deceleration in growth. And while the U.S. may be relatively less effected, the economy would likely suffer through a tightening of financial conditions related to risk aversion in financial markets, rising credit risk, and potential inflation. These channels are sometimes how geopolitical risk is translated into tighter liquidity and more fragile market conditions and could squeeze consumers and corporate profitability, while also complicating central bank policy. As we have seen in the period since the global financial crisis of 2008, policymakers have responded quickly with a range of measures in the face of tightening financial conditions and we would expect a similar response this time around, although inflation risk would present some limitations here. If recession risks were to rise meaningfully, policymakers could prioritize the downside risks to economic growth; higher inflation may not last if it ends up destroying economic activity. 

In the upside-case scenario, we would expect risk appetite to recover quickly as fears about growth and inflation risks subside. As happens in most geopolitical shocks, the most impacted markets in the initial days of the shock tend to rebound rapidly and markets return to the trends in place before the shock.

In the moderate-case scenario, we expect risk aversion to remain elevated generally, with markets rotating toward relative safe-havens from areas most impacted by the conflict. U.S. markets would likely continue to outperform versus Europe and Asia-Pacific while energy and defense-related sectors would likely outperform those most sensitive to energy prices, including airlines and transportation-related industries.

The downside scenario would likely see risk appetite decline sharply as markets move to price in rising recession risk. U.S. markets would likely not be spared, although they could continue to outperform. The U.S. dollar and gold could also rise due to their perceived safe-haven status.

This could be worse in a stagflation scenario, a particularly bad environment where the combination of high inflation and weak economic growth restricts policymakers from moving to an accommodative stance. We have seen some shades of this in recent days as concerns about inflation have put upward pressure on government bond yields due to higher inflation expectations offsetting the demand for perceived safety that typically happens during times of geopolitical shock.