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

As of Tuesday 3 March, hostilities are continuing, with no clear diplomatic off-ramp yet in sight. Financial markets have responded swiftly - but not, so far, dramatically. Oil prices have jumped, equities have moved lower, and traditional ‘havens’, such as gold and the US dollar, have firmed.

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 on the first trading day after the start of the conflict was strikingly measured given the severity of events. Oil prices rose by roughly 10%, while many major equity markets were down only 1%-2% and the S&P500 closed slightly up. Government bond markets priced out some interest rate cuts, gold was slightly higher, and the US dollar index gained modestly.

This pattern tells us something important. Markets appear to be assuming a contained conflict - one in which military action remains geographically limited and Iran’s ability to retaliate diminishes quickly. 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 - especially through the Strait of Hormuz - 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 just under 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.

This helps explain why bond markets have remained relatively calm, all things considered. Investors are balancing higher inflation risks against the possibility of a growth shock if the conflict escalates.

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, 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 5%-15% depending on region, and government bonds may fail to provide their usual diversification benefits. Gold and the US dollar would likely strengthen sharply in this environment.

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 capacity, 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 stocks run low 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, Chinese pressure on Iran to keep the Strait open, 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 government bonds, 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 crosscurrents 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. 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 benefit for clients' portfolios will come from disciplined risk management and appropriate diversification. Over the long term a focus on underlying economic drivers will matter more than reacting to every headline.