Last week’s developments in the U.S.-Iran conflict point to a more significant escalation risk. With the Strait of Hormuz still closed, the reported targeting of Saudi oil tankers in the Red Sea—an alternative shipping route—has expanded the risks beyond a single chokepoint and highlighted vulnerabilities across the region’s energy-export network.

While spare production capacity remains substantial and oil market fundamentals broadly balanced, bringing those barrels to market becomes considerably more difficult when alternative shipping routes are also exposed to geopolitical risk. As a result, investor concerns about a more persistent and severe energy shock have recently intensified.

Brent crude briefly returned to $100/bbl last week, up sharply from the $72/bbl level reached following the interim U.S.-Iran agreement earlier this summer, before retreating to around $90/bbl. Markets are increasingly pricing in a more persistent energy shock, with government bond yields rising as investors reassess the policy outlook. Germany’s 10-year Bund yield hit its highest level since 2011, while the U.S. Treasury 30-year yield is back near pre-Global Financial Crisis levels. 

Equities have also come under pressure. Higher oil prices are reigniting inflation concerns just as investors were already questioning elevated AI-related capital expenditure and stretched technology valuations.

So far, markets have been able to absorb oil at $100 a barrel. Economic growth has remained resilient, earnings have held up, and recession risks have continued to recede, with early second-quarter results in Europe and the U.S. suggesting corporate fundamentals remain healthy. 

However, the key issue is not whether the global economy can tolerate $100 oil, but whether escalating geopolitical tensions push prices materially higher. A prolonged disruption to Hormuz could plausibly drive Brent towards $125/bbl, while sustained disruption to the Bab al-Mandab Strait or Suez Canal would increase the risk of a broader energy shock, spilling over into natural gas and other commodity markets.

The more concerning scenario is one in which geopolitical escalation drives oil sustainably above $125/bbl and meaningfully and sustainably pressures broad supply chains. Our previous analysis suggested that such a disruption could subtract 0.5%-1% from U.S. full-year growth and, more importantly, lift core inflation back above 3.5%. In that environment, the Fed would struggle to remain on the sidelines.

Among major economies, the U.S. remains one of the best positioned to absorb higher energy prices. As a net energy producer, it is materially less vulnerable to supply disruptions than Europe or many Asian economies. Solid labor markets, healthy household and corporate balance sheets, residual fiscal support, and continued AI-related infrastructure spending should help cushion the impact of higher energy costs. The U.S. is therefore not immune to higher oil prices, but absent a much larger shock, any slowdown is likely to remain manageable.

From a market perspective, the most important variable is not oil itself but the Fed’s response. Investors are concerned that higher energy prices could feed into inflation expectations and broader second-round effects. At the same time, Chair Kevin Warsh has provided little explicit forward guidance, leaving markets with limited visibility on the Fed’s reaction function. As a result, investors are approaching the July FOMC meeting with lower conviction than is typical.

Our base case remains that the Fed stays on hold in July and through the end of 2026. Recent inflation data pointed to moderating underlying price pressures, while inflation expectations remain broadly contained. This gives policymakers scope to wait for greater clarity before acting. Although policy rates will be held steady, Chair Warsh will likely maintain a hawkish tone, and a few dissents are likely from other FOMC voting members.

That said, our conviction is low. The longer energy flows remain disrupted, the greater the risk that inflation expectations become unanchored, ultimately requiring a firmer policy response.

Historically, stocks have struggled when inflation-driven tightening cycles resume. While strong corporate profitability suggests a single rate hike would be more likely to moderate returns than derail the bull market, a series of hikes would pose a more significant challenge, particularly given elevated valuations across parts of the U.S. equity market.

A renewed tightening cycle would also threaten the broadening of market leadership that followed the U.S.-Iran truce. If geopolitical concerns intensify further, investors are likely to favor more defensive positioning and a return to U.S. leadership as regions with greater exposure to energy prices underperform. Rising bond yields would add further pressure by increasing corporate financing costs and reducing valuation support.

The renewed rise in oil prices is a reminder that markets remain highly sensitive to geopolitical risk. While the global economy has so far proved resilient, the balance of risks is becoming less favorable as the probability of a more persistent energy shock increases. The key risk is not $100 oil itself, but the possibility that further escalation pushes prices materially higher, reignites inflation pressures, and forces the Fed to reconsider its policy stance.

At the same time, investors are already grappling with questions around AI-related capital expenditure, free cash flow generation, and stretched valuations. Strong earnings growth remains an important support, but may not be enough if higher energy prices and interest rates begin to weigh more heavily on expectations.

Against this backdrop, the investment implications are unchanged: diversification remains critical. As geopolitical, inflation, and policy risks become increasingly intertwined, portfolios should balance participation in long-term growth opportunities with sufficient resilience to withstand a less favorable inflationary outcome.