Since the start of the war between the US/Israel and Iran, financial markets have been oscillating between hope and fear. In March, fear that the conflict would lead to lower economic growth and higher inflation through higher energy prices prevailed, resulting in falling prices in nearly all financial markets. In April, that fear turned into hope that the conflict would end relatively quickly without the escalation that would hit the entire region hard. Stock markets in particular were sensitive to that hope, driven by Trump’s continued optimism about an impending deal combined with evidence that Iran’s escalation dominance was holding. For the rest of the financial markets, that hope was felt less strongly. Investment-grade bonds and precious metals did not recover, and despite significant fluctuations, the oil price ended the month virtually unchanged, well above $100 per barrel. The focus of those latter markets is on the Strait of Hormuz, where the US blockade of Iranian ships has resulted in even fewer ships passing through than was already the case under the Iranian blockade. As a result, the economic and inflationary damage of the conflict to the rest of the world continues to grow, while there is considerable uncertainty about the duration of the mutual blockade.
As we have written in recent months, our focus is also on the Strait of Hormuz. Although Iran’s escalation dominance over Trump has been confirmed multiple times in the past month during so-called TACO moments (Trump Always Chickens Out), the new acronym NACHO (Not a Chance Hormuz Opens) is very apt. To reopen the Strait of Hormuz, a deal must be reached between the US and Iran, and the gap between the two sides remains very wide. The US wants Iran’s nuclear material, while Iran is only willing to pause its nuclear development. And while the US demands free shipping through the Strait, Iran wants to impose a toll to compensate for war damages.
Meanwhile, both sides are using a blockade of the Strait of Hormuz to exert pressure on each other. The problem for the US, however, is that the Iranian regime has repeatedly demonstrated a much higher pain threshold than expected. That should come as no surprise, as the regime is fighting for survival and needs to turn the Strait of Hormuz into the equivalent of a nuclear bomb to prevent future attacks. But as long as the US believes it has the upper hand, the current situation will persist.
Looking ahead, the timeline of this conflict remains essential for us as investors. If the US changes tactics in the coming weeks and a deal is struck to open the Strait of Hormuz, the stock markets in particular may be able to sustain their recovery. They would then look past the economic damage and focus on a less uncertain future. However, if that does not happen, the inflation uptick scenario will become dominant, and stock markets will also have to price in the impact of the conflict through lower earnings expectations. Strong first-quarter earnings, along with Trump’s de-escalation, were a major source of hope. But those earnings will ultimately prove not immune to price increases in virtually all major commodities. And even strong earnings in the technology sector could be indirectly affected if the economy cools further.
Uncertainty therefore remains the key word for describing the situation in the Middle East for the time being. And because the conflict has the potential to significantly impact economic growth and inflation, we continue to believe that some caution in portfolios is prudent. To this end, we have built up a cash buffer that allows us to respond to new developments. We find the optimism currently priced into the stock markets somewhat premature, and we are waiting to see if the Strait of Hormuz reopens and under what conditions before we draw down our buffer.
BY: WOUTER STURKENBOOM (Chief Investment Officer)