Economic impacts of Iran conflict unfold

While there are reports that Iran has made indirect contact with the U.S. to explore a negotiated end to the conflict, the situation remains highly fluid. Outcomes will depend critically on both the scale and duration of hostilities.

With the Middle East acting as a central hub for global oil and gas flows, energy markets have been the primary focus for investors. Oil prices, already rising as geopolitical risk intensified, have climbed from around $51/bbl at the start of 2026 to above $80/bbl, their highest level since mid‑2024. European natural gas prices have reacted even more sharply, rising significantly since the weekend, though they remain well below the levels seen in the early phase of the Russia–Ukraine war.

As concerns grow that the conflict may be more prolonged than initially expected, global risk assets have softened. Even so, U.S. equity market performance has held up relatively well: the S&P 500 remains within 2.5% of its peak, and the STOXX 600 within 5%. The more notable adjustment has occurred in rates markets, where renewed inflation worries have prompted investors to pare back expectations for near‑term central bank rate cuts.

Any further escalation that threatens a full closure of the Strait of Hormuz could have very meaningful implications for energy markets and broader global financial conditions.

The Strait of Hormuz, through which roughly 30% of the world’s seaborne oil supply and 20-25% of global liquefied natural gas exports (LNG) flows, is a critical chokepoint where Iran has historically exerted significant influence. Oil flows from Saudi Arabia, Iraq, Kuwait, the UAE, Qatar, and Iran itself, with the majority destined for Asia. Similarly, gas flows are dominated by Qatar and the UAE, with roughly 80% shipped to Asia and most of the remainder bound for Europe.

Even a temporary tightening of the Strait would materially constrain global oil and gas supply; a sustained closure would be profoundly disruptive. In such a scenario, increased production elsewhere would offer little relief if oil/gas cannot reach end markets.

In a downside case involving a closure of the Strait, oil prices could plausibly rise above $120 per barrel. The longer such a disruption persisted, the greater the risk of spillovers to global growth and inflation. In a more severe scenario, combining a Strait closure with significant damage to upstream oil infrastructure would lead to long-lasting supply losses, and the resulting price response would be even more severe.  

It is therefore worth considering a scenario in which higher energy prices persist:

1. Lower oil intensity: The oil intensity of the global economy has declined significantly over recent decades, implying that prices would need to rise sharply and persistently to materially alter the growth outlook.
2. Producer resilience: Net energy producers such as Saudi Arabia, Norway, Australia, Canada, and the U.S. are more insulated from energy price shocks. Even so, in consumer‑driven economies like the U.S., higher energy prices still weigh on households despite increased activity and profits in the energy sector.
3. European vulnerability: Europe is heavily exposed to any disruption in Qatari and UAE gas supplies and remains a net oil importer (with Norway the key exception). As a result, the European economy is particularly sensitive to rising energy prices, with some estimates suggesting the growth impact could be roughly twice that experienced in the U.S.
4. Asian exposure: Energy‑intensive economies in Asia, including Korea, India, Japan, and China, are also relatively vulnerable. Although Iran accounts for only around 3.5% of global oil production, an estimated 90% of its exports are sold to China, posing a meaningful risk to the Chinese economy.
5. Inflation implications: Inflation effects could be significant. In the U.S., while our baseline forecast sees inflation ending 2026 around 2.5% as tariff effects fade, a sustained increase in oil prices could push headline inflation above 3%. Core inflation would likely rise more modestly.

Central banks: a difficult dilemma

Energy price spikes raise inflation while weighing on growth, creating a challenging trade‑off for central banks. Historically, U.S. equities have struggled most during geopolitical crises when the Federal Reserve tightened policy despite deteriorating financial conditions. In those episodes, rate hikes weighed more heavily on returns than the geopolitical shock itself.

Since the oil shocks of the 1970s and 1980s, the Fed has typically refrained from tightening policy in response to supply‑driven inflation. However, the recent inflation episode, initially driven by pandemic‑related supply constraints and amplified by the energy shock following Russia’s invasion of Ukraine, may have lowered the threshold for a policy response to large and persistent energy price increases.

Indeed, in recent days, market expectations for Fed rate cuts this year have declined, while expectations for ECB tightening have increased. Our baseline forecast remains two 25bp Fed cuts in the second half of the year, with no change in ECB policy. While we are not revising those forecasts at this stage, that could change if energy prices remain elevated and the conflict persists. A full closure of the Strait of Hormuz would likely push central banks globally toward a more hawkish stance to prevent a de‑anchoring of inflation expectations.

Market outlook and investor considerations

Market sentiment had already softened in recent weeks amid AI‑related uncertainty and valuation concerns weighing on risk appetite. Against this backdrop, a fresh geopolitical shock that pushes oil prices materially higher, with possible spillover effects on growth and inflation, could amplify volatility. The longer the conflict extends and the greater the disruption to energy supplies, the more vulnerable the global economy is. After already absorbing multiple macro and geopolitical shocks this year, risk assets have become increasingly vulnerable to negative surprises.

That said, the underlying strength of the global economy, the robustness of household and corporate balance sheets, and continued momentum in global earnings growth suggest that any market drawdown should remain contained.

As a net energy exporter, the U.S. economy remains relatively less vulnerable to higher oil and gas prices.

Principal Asset Management