Two outsized geopolitical risks have been on the market's radar for years, though not always with equal prominence. The first is an escalation in Taiwan, and the second is one in the Strait of Hormuz. The latter is the transit point for 20% of the global oil supplies; the fear is that the interruption of physical barrels would make the war matter to households and businesses globally (though the world currently has three months of storage). However, Iran has not truly tried to close the Strait since the 1980s, and even now has only done so to American-flagged vessels. Having said that, this is the second time in 9 months that the US has attacked Iran after 46 years of severe animosity without direct conflict, and the possibility should absolutely not be discounted.
If Iran were to, for example, use drones to close shipping lanes, that would be a major escalation. It would also be met with massive retaliation, not to mention the fact that Iran's own oil exports rely on the Strait. Historically, the Iranian regime has not been a reckless gambler and has been more likely to play for time than to pursue actions that pose existential risk. Retaliation has frequently been more performative than escalatory. However, given the death of most members of the leadership team, the behaviour of Iran's current leadership is untested. Already, Iranian foreign minister Aragchi has noted that some of Iran's military units are independent and isolated, acting on their own with general instructions provided in advance.
Devolution of authority to local units has allowed Iran to avoid the paralysis it exhibited on the first day of the 12-Day War in June 2025, but it also increases risks. Ultimately, a Hormuz closure scenario remains a low-probability, high-impact tail risk. That is the critical variable for whether attacks remain contained or spiral into a broader conflict. As of the night of Sunday, 1 March, we expect that the conflict will last weeks, not days. However, the critical variable is not length but intensity. There are significant downside tail risks if the domestic transfer of power in Iran were to be contested with force, leading to a Syria-type civil war. There are, however, upside tail risks if the new Iranian leadership were to change its attitude towards the United States and negotiations were to commence.
In the short term, should an Iranian response to the American and Israeli operation, which has been planned for months, include closing shipping lanes or attacks on regional infrastructure in Saudi Arabia and the UAE, the impact on financial markets would operate mainly through the oil price, which has already priced in higher risk premia despite efforts by OPEC to increase supply. Macroeconomically, it would operate through the uncertainty channels as embedded in the US Federal Reserve Board and New York Fed models. The effect would be stagflationary, i.e., inflation rising and growth slowing.
A 30% real increase in oil prices would, on those estimates, lift headline inflation by around 1 percentage point over a year while reducing output growth by roughly 0.13 percentage points, with the uncertainty channel amplifying these effects further. The effects on inflation expectations could also be significant, depending on the size and duration of the ultimate shock. That may complicate the Fed's path lower this year. However, energy equities and energy-linked sovereigns can benefit, even as energy importers (such as Japan and India) face a higher import bill.
The crisis in Iran was well telegraphed, but it arrives at a time when markets are already digesting significant churn beneath the headline index numbers. Under the surface, fragility has been evident in sharp first-quarter sector rotations, most notably the sell-off in software and emerging cracks in developed-market private assets. The spread of agentic AI has prompted a reassessment of traditional SaaS moats. The IGV software ETF is down around 20% year to date, and valuation multiples for prominent software names have compressed. That weakness has spilt over into publicly listed developed-market private credit vehicles with heavy software exposure, particularly US Business Development Companies. At the same time, investors have reassessed businesses with tangible assets and lower perceived obsolescence risk, amid concern about rapid AI diffusion, especially across labour markets. Some software firms have responded by cutting headcount and trimming future stock-based compensation.
There was also a marked sell-off in metals prices in January after a sharp run-up. The dollar remains lower year to date. In short, markets were already adjusting before this latest geopolitical escalation. That adjustment has been partially absorbed because growth remains firm and inflation is easing. There is also a reflexive element. Strong asset prices have coincided with a low savings rate, supporting consumer spending in the upper half of the K-shaped recovery. The key question now is whether events in Iran disrupt that balance, and we will update our views accordingly.
