Iran conflict sparks geopolitical shockwave as markets brace for impact

Twelve days ago, Israel launched a major military campaign targeting Iranian nuclear facilities, air defense, surface-to-surface missile sites, and senior military and scientific personnel. Over the weekend, the conflict escalated significantly as the United States directly intervened, striking three nuclear sites inside Iran.

The situation remains highly fluid, with growing concerns about Iranian retaliation and the broader consequences of U.S. involvement.

Market reaction

A general risk-off tone has returned to markets, although the overall equity market reaction has so far (up to June 20) been muted, with stocks focusing instead on macroeconomic data and central bank meetings. Investors have sought refuge from geopolitical uncertainty in traditional safe havens, although notably, there has been a greater rally in gold, Japanese yen, and Swiss franc than in the U.S. Treasury market and the U.S. dollar.

Recently, oil prices have recorded one of the sharpest rises in the past 30 years, jumping more than 20% in a week and surpassing $70 per barrel. Even so, as of June 20, oil remained below its 2024 average of $80 and is meaningfully below the levels reached in previous geopolitical shocks.

However, it is worth noting that if the conflict escalates further, threatening disruption to the flow of oil, there could be additional sharp and sustained upward pressure on energy prices.

The tail risk scenario

Until this weekend, while both Israel and Iran had traded retaliatory blows, they had so far avoided the most escalatory steps. Following the U.S.’s involvement, the risk of an Iranian attack on the Strait of Hormuz has significantly increased.

A disruption in the Strait of Hormuz would have a profound and significant impact on oil and gas flows, presenting a meaningful risk to both global trade and oil prices:

Gas: Roughly 20-25% of global liquefied natural gas (LNG) exports pass through the Strait of Hormuz. These volumes primarily originate from Qatar and the United Arab Emirates. Approximately 80% of this LNG is shipped to Asia, with most of the remainder bound for Europe. Notably, there are no alternative pipelines available to re-route these flows.

Oil: Around 30% of the world’s seaborne oil supply passes through the Strait. Volumes come from Saudi Arabia, Qatar, Kuwait, UAE, Iraq, and Iran, with the bulk of the oil destined for Asian markets. Due to limited pipeline capacity, re-routing would still leave the global market short of oil supply. Compounding the risk, much of the world’s space production capacity would also be inaccessible, leaving few options to offset the drop in supply.

On the other side, further retaliation from Israel/U.S. could result in an attack on Kharg Island – key to Iranian oil exports. Although Iran only produces around 3.6 million barrels of oil per day, accounting for just 3.5% of global production, it is estimated that around 90% of Iranian oil exports are sold to China, suggesting a significant risk to the Chinese economy.

In the most negative scenario – a complete disruption to Iranian oil supply and a closure of the Strait of Hormuz – estimates suggest that oil could rise to above $120 per barrel. OPEC+ does have spare capacity, and U.S. production has the flexibility to increase, so it may be able to offset some of the upside price pressures. However, the likely fallout from such a disruption would be very difficult to mitigate fully.

The geopolitical conflict playbook

By their very nature, geopolitical developments are fluid, and so it will be difficult to predict exactly how the Middle East conflict will play out over the coming days, weeks, and months. Past geopolitical shocks, however, can provide investors with insight into how markets typically respond and the duration of that response.

• Over the last 60 years, most geopolitical events have often been short-lived and have rarely had a sustained significant impact on equities. The median sell-off has been around 7%, typically taking around three weeks to reach a bottom and an additional three weeks to recover to previous levels. What’s more, after three months, the market was, on average, 4% higher. Steady positive economic growth, corporate performance, monetary policy, and valuations tend to matter much more than short-term market uncertainty, so, in the longer run, it’s the underlying economic backdrop that will dominate market trends.
• While regional conflicts do not necessarily directly affect the broader market, oil prices can serve as an important transmission mechanism to the economy, and central bank reactions to oil price moves are equally important.
• During the two Gulf wars, the Federal Reserve refrained from tightening monetary policy, and the economic backdrop remained solid. While equities initially sold off sharply, markets fully recovered – and even posted meaningful gains – within nine months. Similarly, the 2019 drone strikes on Saudi Aramco by Iran and others, which knocked out 5% of global oil production overnight, triggered only a brief spike in oil prices. These examples illustrate the difficulty of forecasting the medium-term path of energy markets, even in the face of significant geopolitical shocks.
• By contrast, when central banks have responded to rising oil prices by tightening monetary policy, the equity market sell-off has been more prolonged. During the oil embargo of 1973, for example, the Fed hiked interest rates aggressively to counter the inflationary impact. As a result, bond yields soared, and the subsequent equity market sell-off took several years to recover. Similarly, the Russia-Ukraine conflict in 2022 began against a backdrop of already sharply rising inflation concerns, with the surge in gas and oil prices reinforcing expectations for an aggressive Fed response to inflation fears.

A vulnerable moment

With oil prices still under $80 per barrel (as of June 20) and most global central banks at different stages of their rate-cutting cycles, the current situation in Iran doesn’t really compare to either the 1973 or 2022 episodes.

As it stands, the global economy can likely absorb the economic impact of this geopolitical conflict without significant fallout. In the U.S., real income growth remains solid, and consumer spending on energy as a percentage of income is at a near-record low, suggesting that consumption can handle some degree of higher oil prices. Additionally, U.S. businesses continue to enjoy elevated profit margins, providing them with some cushion against higher energy prices.

Still, the economy remains vulnerable to a significant rise in oil prices. Depressed energy costs have been a key factor in keeping inflation in check in recent months. With the Fed already expecting U.S. inflation to rise above 3%—in part due to new tariffs—any sustained increase in oil prices could further strain consumers and delay anticipated rate cuts. This would come at a time when cracks are already emerging in the labor market, and some degree of policy support is likely to be needed.

Meanwhile, global uncertainty is already elevated following the U.S. move to impose new import tariffs. A worsening conflict that drives oil prices sharply higher could further damage market sentiment, undermine capex plans, and weigh on earnings. Having already absorbed a series of shocks this year, risk assets remain highly sensitive to additional negative surprises.

Market implications and asset allocation decisions

History suggests that making dramatic portfolio changes in response to geopolitical crises is often a mistake. Market performance tends to be driven more by underlying macroeconomic conditions than by short-term shocks. While the global economy faces several headwinds, it remains resilient enough to absorb a moderate increase in oil prices.

That said, the risk of a sharp spike in oil and a broader hit to market sentiment cannot be ruled out. In this environment, it’s essential for investors to maintain well-diversified portfolios designed to navigate periods of heightened uncertainty.

Global diversification: While a severe spike in the price of oil resulting from an attack on the Strait of Hormuz would impact the global economy, some economies would be less exposed than others.

• U.S. - As a net energy exporter, the U.S. is less vulnerable to a rise in oil and gas prices – and U.S. oil production may even benefit from higher prices. However, any oil price increase would add to the tariff-driven inflation surge that is already expected, likely further delaying Fed cuts.
• Europe - By contrast, Europe is a net importer of oil and LNG. Any disruption of supply would have a more significant impact on energy prices across Europe. However, the region has gradually reduced its reliance on LNG from the Middle East, and it is, therefore, less exposed than it once was.
• Asia - Asian oil importers, such as India and Indonesia, are among the most exposed to an oil price shock, given their heavy reliance on Middle Eastern crude. China, in particular, is highly vulnerable to any disruption in Iran’s oil infrastructure, as it accounts for roughly 90% of Iranian oil exports.

Quality - The story remains the same—market conditions have grown more challenging due to U.S. policy uncertainty, shifting trade dynamics, tariff-driven inflation, and now, rising geopolitical risks. In this environment, companies with robust balance sheets, resilient business models, and pricing power are best positioned to outperform.

Energy and Defense – Energy has underperformed in recent months, but higher energy prices would drive a stronger performance. With the sector also positioned to benefit from deregulation, recent weakness may present a buying opportunity. Defense has been a strong performer so far this year, particularly in Europe, as governments prepare to increase spending on military equipment. Middle Eastern geopolitical tensions are likely to continue supporting defense stocks.

Gold – Gold has been a major beneficiary of safe-haven flows, more so, in fact, than the U.S. dollar. This serves only to reinforce the growing narrative of U.S. dollar weakness, driven not just by cyclical U.S. weakness but also by longer-term concerns about the reliability and strength.

Principal Asset Management