Iran: Contained conflict or sustained oil shock? The triggers you can't ignore

As of Thursday 5 March, hostilities are continuing, with no clear diplomatic off-ramp yet in sight. Financial markets have responded swiftly - but not, so far, in a disorderly way. Oil prices have jumped and equities have moved lower. The performance of traditional ‘havens’ has been mixed, with the US dollar firming, but government bonds and gold selling off.

The key question for investors is whether markets are underestimating the risks or correctly judging that this conflict will remain intense but short-lived.

What markets are pricing now

The market response over the first three trading day after the start of the conflict is, at first glance, strikingly measured given the severity of events. Oil prices are up by roughly 15% to $83, but well short of the $100-plus mark many had thought closure of the Strait of Hormuz would imply.

The major equity markets vary between unchanged in the case of the S&P500 in the US, to 10% down in the (previously very well performing) KOSPI in Korea. The US dollar index has gained on flight-to-safety. By contrast, government bond markets have sold off as investors have priced out some interest rate cuts. We think that bonds will increasingly not perform their traditional safe-haven role as inflationary shocks become more frequent. More surprising, from our perspective, is that gold prices are slightly lower. This seems to reflect investors selling previous “winners” to raise a bigger protective cash buffer.

Taken together, this pattern tells us something important. Markets appear to be assuming a contained conflict - one in which Iran’s ability to retaliate diminishes quickly and the current closure of the Strait of Hormuz is short-lived. In other words, investors are not ignoring the conflict, but they are pricing a specific outcome rather than a worst-case scenario.

Our economists assign roughly a 60% probability to this baseline. Under this scenario, US and Israeli airstrikes continue for weeks rather than months, degrading Iran’s military capability. Iranian retaliation persists in the near term and includes notable successes from their perspective, but fades as missile stocks are depleted and launch systems are targeted. Crucially, disruption to global energy supply is assumed to be short-lived.

Why oil matters more than headlines

For investors, oil is the transmission channel that matters most. Around 20% of global oil supply passes through the Strait of Hormuz, along with liquefied natural gas shipments that cannot easily be rerouted. Even brief disruption can move prices sharply, as markets have already shown.

As a rule of thumb, a 10% year-on-year rise in oil prices adds around 0.2 percentage points to inflation in major economies. With oil already up sharply in recent weeks, a sustained increase could add around 0.5 percentage points to inflation, potentially slowing the pace of interest-rate cuts in the US, UK and parts of emerging markets — but not, on its own, triggering recession.

But what if it’s escalation, not calm?

Although an intense but short conflict is the baseline, the downside risks are significant. Our team assigns roughly a 30% probability to a more severe scenario involving further dramatic escalation and a longer-lasting conflict, with bigger negative economic and market consequences.

This could occur if Iran succeeds in sustaining disruption to shipping through the Strait of Hormuz for a lot longer, steps up attacks on Gulf energy infrastructure, or inflicts significant US military casualties. Under such conditions, oil prices could rise well above US$100 a barrel, equities could fall further, and government bonds would sell-off more as inflation forecasts moved upwards. The US dollar would likely strengthen sharply in this environment, and ultimately we would expect gold to do well too.

Importantly, this is a stress-test scenario that already formed part of our process going into these events — one that portfolio and risk teams are actively monitoring and modelling.

There is also a smaller upside scenario, with perhaps a 10% probability, in which the conflict ends very quickly, and oil prices ultimately fall below pre-conflict levels. However, this is considered unlikely at this stage given the scale of recent strikes and retaliation.

What would signal a change in market thinking?

For investors, the most important signals to watch are not daily headlines but a handful of strategic waymarks.

First, communication from the US on the duration of the conflict matters. President Trump has spoken about a conflict lasting four weeks to fully degrade Iranian military capability, but has also said the operation is going better than expected. Rhetoric pointing to regime change would raise the risk of escalation and a longer conflict. By contrast, a shift towards declaring military objectives achieved, or an increase in domestic US pressure to wind up the strikes, would shorten expectations for the duration.

Second, the pace and effectiveness of Iranian retaliation will be critical. Continued successful strikes on civilian or energy infrastructure, or widening involvement from Iran’s regional proxies, would challenge current market assumptions. A visible decline in strike frequency as Iranian missile stock run low and their retaliatory abilities are degraded would support them.

Finally, oil and gas supply disruptions remain the key variable. Prolonged closure of the Strait of Hormuz or sustained shutdowns of Gulf production facilities would have far more serious macro and market consequences than those currently priced. On the other hand, a successful US military operation to re-open the Strait, Chinese pressure on Iran to let oil tankers through, or the US releasing oil supplies from its strategic reserve, would reassure energy markets.

Portfolio implications: stay diversified, avoid knee-jerk moves

Against this backdrop, our core medium-term investment views remain unchanged. We continue to see value in risk assets over a 12 to 18-month horizon, retain a modestly positive stance on income-generating assets such as bonds and real estate, and hold a neutral view on the US dollar over that timeframe.

That said, near-term market dynamics are likely to be volatile. The US dollar may find short-term support from risk aversion. Bonds face cross-currents from higher inflation risk and flight-to-safety demand. In this specific supply-side shock, commodities - particularly precious metals - may offer more effective diversification than government bonds.

Within equities, relative performance matters. The US is a net energy producing so is more insulated from this shock, while Europe and Asia are more exposed. Sectors such as energy, defence, utilities and healthcare may prove more resilient, while energy-intensive industries, airlines and tourism could face greater pressure if disruption persists.

Final thoughts

Markets are not complacent about events in the Middle East — but they are making a judgement that this conflict will remain contained and finite. That judgement could yet prove flawed.

For investors, trying to predict geopolitical outcomes is unavoidable, but ultimately very difficult. That’s why we have laid out clear waymarks around the US’ war aims, Iran’s response and changes in oil supply.

But the real value-add for clients’ portfolios will come from disciplined risk management, appropriate diversification, and a focus on underlying economic drivers will matter more over the long term, rather than reacting to every headline.