Asset Allocation: Does Middle East Conflict Change the Calculus?

The Middle East conflict and its uncertainties, together with a shaky job market, challenge risk assets and growth. Vigilant of the risks on all fronts, we remain constructive in our positioning.

There has been significant volatility across risk assets since the U.S.-Israel military strikes on Iran commenced nine days ago, but the moves thus far have been largely within expectations, given the scale of what is at stake. 

These profound events have fundamentally altered the geopolitical landscape of the Middle East and forced the de facto closure of the most important energy chokepoint in the world, the Strait of Hormuz.

Approximately 20 million barrels of oil per day and nearly a fifth of global LNG supply transit through the Strait, underscoring the severity of the energy price shock risk to the global economy if it remains impaired for any meaningful duration, the key variable in our scenario analysis, “Risks to Oil from Iran: The Price Uncertainty Flows Through Hormuz”.

As we outlined in that analysis, there are four likely scenarios and in three of them, including a regime change, the disruption—while serious—remains manageable for global growth. However, it is the fourth—a prolonged, intense conflict with sustained interruption to oil flows over many months—that introduces a genuine risk of meaningful equity correction and the kind of demand destruction that would alter our outlook materially.

While we do not assign a high probability to that outcome at this stage, we are watching closely for it. Indeed, at the time of writing, there was little sign of deescalation, and the Strait was essentially closed, pushing oil and natural gas prices up toward their highest levels since Russia invaded Ukraine in 2022.

As striking as those price moves are, Friday’s unexpectedly weak U.S. nonfarm payrolls print served as a sharp reminder that the conflict is not the only force complicating the macro outlook.

Ricocheting Risk Markets

After a difficult and volatile week, it is important to step back and assess the relative price moves that have occurred thus far across asset classes.

The broad commodity reaction has, by and large, made sense. Simple supply and demand dictated substantial spikes in energy prices. The volatility profile and backwardation in crude, the spike in European energy and LNG—all of it has been in line with our expectations given the circumstances. Gold also dipped initially—a minor surprise—before reasserting its safe-haven credentials.

Within equities, the response has been more nuanced. Non-U.S. market declines have been broadly in line with what we would have expected, but the resilience of the U.S. market stands out, particularly given elevated valuations. The most plausible explanation, in our view, is a safe-haven rotation anchored by dollar strength, with investors de-risking into U.S. assets as a defensive play. Europe and Asia’s greater dependence on energy imports compounds their vulnerability, reinforcing the relative appeal of U.S. assets as a defensive destination.

Currency markets have told a similarly intuitive story: the dollar has been one of very few assets in positive territory, with developed-market currencies selling off against it and energy-exposed emerging market currencies hardest hit.

Where markets have genuinely surprised us is in rates. Sovereign bond yields have risen sharply across the curve—including a 20-basis-point spike in the U.S. 10-Year Treasury—while at least one expected rate cut has been effectively priced out by the Federal Reserve, European Central Bank (ECB) and Bank of England alike. The move reflects both rising breakeven inflation and higher real rates, a combination that has defied the usual playbook: in a supply shock, inflationary concern would ordinarily be at least partially offset by a flight-to-quality bid for government bonds. That bid appeared fleetingly on the weekend of the strikes before reversing decisively.

Fixed income markets are now pricing inflation permanence without the offsetting safe-haven demand, pushing yields higher on both sides of the Atlantic and, in the case of the ECB forward curve, implying outright rate hikes. Given the genuine ambiguity around how long disruption lasts and whether higher energy costs prove transitory, that is a notably one-sided thesis—and one we are watching closely.

Constructive in an Evolving Context

For all the turbulence, global equities have been fairly resilient relative to the severity of developments, a reflection of the underlying strength of corporate earnings and the broader growth trajectory that defined the investment landscape coming into this period.

Much has happened, however, and the fundamental pillars of our constructive positioning are being tested. The energy shock from the conflict is our primary concern at this time, but fragility in the U.S. jobs market is an important focus.

Nonfarm payrolls fell 92,000 in February—well short of an estimated gain of 55,000—marking a stark reversal from January’s strong tally of 126,000 new jobs. The decline was led by a drop in healthcare employment following widespread strikes by medical workers. Tech employment also slid, while federal government job cuts continued.

Worrying as both developments are, neither—in isolation or together—has yet dislodged our base case. But both have the potential to do so.

Our reassessment threshold is not solely an oil price trigger, though crude sustained near or above $100 per barrel for several months would require a meaningful revision of our outlook, as we discussed in our webinar, “Assessing the Iran Strikes: Geopolitical Risks and Portfolio Implications”. 

The weak jobs print is a reminder that signs of labor market fragility cannot be ignored.

A More Complex Calculus

For now, we believe the more likely outcome is a perpetual but modest risk premium being embedded into energy prices—an adjustment the global economy can absorb—rather than a structural break in the growth cycle.

The buffer is thinner than it appeared a month ago, but it has not yet been exhausted. That assessment is reinforced by the Administration’s clear willingness to use military force to protect shipping through the Strait and a broader strategic need to maintain its stability.

This being said, we are not complacent. Should subsequent labor market data confirm a more sustained deterioration, the inflation-versus-slowdown dynamic would shift materially—and so would our positioning.

Markets are right to be unsettled. A geopolitical shock of this magnitude arriving alongside an unexpected softening labor market is a genuine test of the constructive thesis, and we are not dismissing it as noise. But unsettled is not the same as correction, and complexity is not the same as deterioration.

The calculus has become harder; it has not yet fundamentally changed. We remain constructive on risk assets and growth over the medium term, and we regard episodes of material weakness not as reasons to retreat, but as potential opportunities to lean further in.