The war between the US/Israel and Iran is still in full swing, and the financial markets are closely monitoring every news item. Hopes for a quick victory and regime change in Iran have now faded, but hopes that President Trump will unilaterally withdraw have risen significantly following his latest remarks. Trump is selling his military loss as a victory, but in reality, he recognizes Iran’s escalation dominance. Iran has gained the upper hand by, on the one hand, closing the Strait of Hormuz and, on the other hand, drawing the entire region into the conflict. As a result, Iran has time on its side while it can credibly threaten that a ground invasion or attacks on its energy and water infrastructure will lead to retaliatory strikes on those same targets throughout the region. This would, of course, have major negative consequences for the region, energy prices, and financial markets. And because Trump does not want to bear the political consequences of that, he is now willing to withdraw unilaterally. The pain threshold of a regime fighting for survival is simply much higher.
Although financial markets ended March on a positive note, returns for the month as a whole were very negative. Uncertainty surrounding the conflict and the associated declining growth expectations and higher inflation expectations weighed heavily. This simultaneously affected stocks, bonds, and precious metals, and so, as feared, we saw the return of positive correlations.
As we wrote last month in “Risk vs. Uncertainty,” we evaluated the probabilities of our scenarios for 2026 immediately after the outbreak of the war. This gave us insight into a shift in risks and the potential impact of the conflict, despite the uncertainty regarding its duration and scope. Based on this, we decided to lower the risk of the portfolios by selling equities. We also formulated a number of points to consider for potential next steps. An escalation targeting energy and water infrastructure in the region, a ground invasion, and/or the closure of the Bab al-Mandeb Strait by the Houthis would require further reductions in risk. Conversely, “regime change” in Iran and/or a ceasefire in conjunction with the reopening of the Strait of Hormuz would call for an increase.
Israel’s attack on Iran’s South Pars gas field and Iran’s counterattack on Qatar’s Ras Laffan gas terminal were the kind of escalation we feared, and the reason for further reductions in equities. In addition, we have reduced our position in long-term government bonds. This conflict is still ongoing, very difficult to resolve, and disastrous for shipping traffic through the Strait of Hormuz.
Although a potential unilateral withdrawal by the US and Israel effectively means that the Iranian regime emerges victorious from the conflict, it is understandable that financial markets are initially reacting positively. The negative scenario of further escalation has, after all, become less likely. But that does not mean that all the negative consequences of the conflict have disappeared. For now, the harsh reality is that the regime in Iran is holding its ground, is capable of continuing to fight, and is capable of keeping the Strait of Hormuz closed.
Looking ahead, the most important question is therefore what Iran will do. Now that it knows Trump wants to withdraw quickly, it can sit back and wait, keep the Strait of Hormuz closed, and maintain its escalation dominance through regular but limited attacks on neighboring countries and ships. For the regime’s survival, it is essential that the course and outcome of this conflict create a deterrence. Such deterrence must prevent future attacks, and the Strait of Hormuz must serve as the equivalent of a nuclear bomb. Depending on the regime’s assessment of when that goal has been achieved, it will reopen the Strait (in exchange for payment). For us as investors, the timeline is crucial. If this all happens quickly, we remain in our Boom-Bust scenario with the possibility of recovery; if it takes longer due to negotiations over, for example, security guarantees, we enter our Inflation uptick scenario. We are already seeing that price increases in oil, gas, aluminum, fertilizer, diesel, and kerosene are filtering through to the broader economy. And that list of affected products only gets longer with every week that the Strait remains closed.
Of course, escalation dominance is never absolute. President Trump and Israel could still conclude that the continued existence of the Iranian regime with permanent control over the Strait of Hormuz is a bad idea in the long term. Before the conflict, approximately 135 ships passed through the Strait each day. At an estimated toll of $2 million per vessel, Iran would gain a significant revenue stream. The surrounding countries will not welcome this outcome either. In addition, Israel in particular is concerned about the estimated 400 kg of 60% enriched uranium that Iran still possesses. There is therefore still a possibility that one or more parties will escalate the situation to open the Strait and/or acquire the uranium. For us as investors, this would mean shifting from our Boom-Bust scenario to the Recession scenario.
Of course, there is also a middle ground, in which the conflict drags on for weeks or even months without large-scale escalation. With each passing week, that outcome will gradually reduce the likelihood of the Boom-Bust scenario — like a cascade — in favor of first the Inflation Uptick scenario and then the Recession scenario. A positive scenario is, of course, still possible if an unexpected regime change occurs and/or a ceasefire is negotiated, opening up the Strait of Hormuz.
As we wrote last month, the situation in the Middle East is highly uncertain, and the ultimate impact on economic growth and inflation is potentially very significant. This combination calls for caution, which we have reflected in our portfolios through several adjustments. Looking ahead, we are wary of further escalation but also note that that risk has diminished somewhat following President Trump’s remarks. That does not, however, change the fact that as long as the Strait of Hormuz remains closed, the damage from the conflict to the global economy continues to mount. The big question is what Iran will do, and that is difficult to predict. There are differing views within the regime. Their strategy of regional escalation and global impact has worked, and they will not simply give up those trump cards in exchange for “security guarantees.” That is surely not going to happen while the US and Israel are still carrying out active attacks. For now, we therefore remain cautious and are waiting to see if the Strait of Hormuz reopens and under what conditions.
BY: WOUTER STURKENBOOM, Chief Investment Officer