U.S. & Israel vs. Iran: A sharpening geopolitical fault line

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On February 28, the U.S. and Israel launched coordinated military operations against Iran, citing the need to neutralize “imminent threats from the Iranian regime.” Iran has since retaliated with missile strikes against U.S. bases and U.S.-aligned targets across the Middle East. The conflict has escalated meaningfully since the weekend following the death of Iran’s Supreme Leader and several senior commanders.

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 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.

Geopolitical shocks are inherently difficult to forecast. Although uncertainty can spark sharp market reactions, history suggests that equity sell‑offs driven by geopolitical events are typically short‑lived.

Over the past six decades, most geopolitical crises have led to temporary market drawdowns, with a median peak-to-trough decline of around 7%. Markets have typically needed around three weeks to bottom and another three weeks to recover. After three months, equities have historically been about 4% higher.

The major exception occurs when geopolitical events materially alter economic fundamentals, trigger a policy response from central banks, or coincide with periods of broader macro vulnerability. In this context, oil prices are the most important transmission mechanism from geopolitics to the real economy.

Despite persistent tensions in the Middle East, sustained oil price spikes have been rare. The 2019 Houthi attack on Saudi Arabia’s Abqaiq facility temporarily removed around 5% of global oil supply and sent prices up 15% overnight, yet the move fully reversed within weeks. Similarly, last year’s U.S. strikes on Iran led to a brief 4-5% rise in oil prices, which quickly unwound, with equities rebounding just as rapidly.

From a supply‑demand perspective, oil markets currently appear reasonably well supported. Global supply is running ahead of demand, several Middle Eastern producers increased exports last month, and OPEC+ has agreed to lift production. Inventories, therefore, provide some buffer, though they are leaner than before Russia invaded Ukraine, and spare capacity within OPEC+ remains uneven.

The more acute risk lies in shipping disruptions, not production. 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.

That said, while Iran has repeatedly threatened to close the Strait, it has never followed through. Significant domestic constraints, including high inflation, shortages of essential medicines, a deteriorating economic backdrop, and rising social unrest, likely limit Iran’s capacity to sustain a prolonged, high‑intensity conflict.

For now, the global economy appears capable of absorbing a moderate, temporary rise in energy prices. U.S. growth remains robust, capital expenditure is strong, and household energy spending as a share of income is near historic lows. Corporate profit margins also remain elevated, providing a buffer against higher input costs. Europe is enjoying a tentative growth revival, while Asia remains a key engine of global expansion, driven by AI‑related investment, resilient tech exports, and healthy domestic demand.

But fragilities remain. Inflation has eased but remains above central bank targets, and a sustained rise in oil prices would place renewed pressure on consumers while potentially delaying anticipated rate cuts. This is particularly relevant in the U.S., where affordability concerns are already politically and economically sensitive.

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.

Moreover, 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 could amplify volatility. After already absorbing multiple macro and geopolitical shocks this year, risk assets are increasingly vulnerable to negative surprises.

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 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.

History strongly argues against making dramatic portfolio shifts in response to geopolitical events. While our constructive medium‑term macro outlook remains intact, the unpredictability of the current episode reinforces the importance of diversification and resilience.

Portfolios should remain positioned for continued global growth, while maintaining exposure to assets that tend to perform well during periods of heightened risk aversion. These include gold, high-quality assets, and selective commodity exposure. In addition, sectors that typically benefit from elevated geopolitical tensions, such as defence and aerospace, can help mitigate downside risk. As a net energy exporter, the U.S. economy remains relatively less vulnerable to higher oil and gas prices.

In an increasingly fragmented and volatile global order, disciplined diversification remains one of the most effective tools investors have to navigate uncertainty while staying aligned with long‑term objectives.