How could the Middle East conflict evolve?

Developments in the Middle East remain the key determinant of economic and market performance in the second half of 2026. With the Strait of Hormuz still closed, the window for a quick reversal of the economic damage from disrupted oil and gas supplies is narrowing. A resolution could come at any time, but for now, neither Washington nor Tehran appears able to untangle the deadlock. Below, we outline possible scenarios and what they could mean for investors. We continue to view the first scenario—reopening the Strait—as the most likely outcome.

Reopening in the near term

Backdrop

Both sides maintain the ceasefire and agree to reopen the Strait of Hormuz. Shipping traffic returns to pre-war levels within 6–8 weeks.

Economic reaction

• Energy prices remain elevated (oil around USD 80–USD 90 per barrel) as governments and businesses rebuild inventories and strategic reserves.
• Shipping insurance costs may remain higher for longer and be passed through to energy prices.
• Headline inflation likely stays elevated through 2H 2026 and early 2027, then gradually declines.
• Consumption takes a modest hit as higher energy and food prices reduce disposable income.
• Corporate capital spending (capex)—especially on artificial intelligence (AI)—remains solid.

Policy reaction

• The U.S. Federal Reserve (Fed) may hold rates steady and maintain a wait-and-see approach; rate cuts look increasingly unlikely in 2026.
• More inflation-focused central banks (e.g., the European Central Bank and the Bank of England) may implement modest rate increases to pre-empt inflation pressure. These moves could be reversed later if inflation expectations remain anchored near targets.
• Governments will likely continue supporting households and businesses through subsidies or income supplements. Fiscal deficits may rise, but bond investors may view these measures as temporary—limiting the risk of a sharp increase in government bond yields.

Market implications

• While government bond yields may stay elevated amid sticky inflation, the U.S. Treasury curve would likely bull steepen (front-end yields falling relative to the long end) as central banks focus less on further tightening.
• A return of risk-on sentiment could support global equities. Recent laggards—such as cyclically sensitive sectors—may catch up, broadening market performance.
• The U.S. dollar would likely depreciate versus major currencies as risk appetite improves.
• Improved clarity on global growth could support appetite for private credit and private equity.

An extended closure of the Strait of Hormuz

Backdrop

Despite the ceasefire, neither Tehran nor Washington is willing to make concessions to reopen the Strait. Shipping traffic in and out of the Gulf remains well below pre-war levels for much of 2H 2026.

Economic reaction

• Global inventories continue to be drawn down rapidly.
• Pressure extends beyond oil and natural gas; petrochemicals used for fertilizers and many industrial inputs are also affected.
• Rising oil and gas prices push inflation higher, while economic activity weakens due to rationing of raw materials and “demand destruction” (reduced demand because prices are too high).
• Asian economies are likely more vulnerable than the U.S. and Europe due to greater reliance on Gulf energy and raw materials. However, given Asia’s role in global supply chains, disruptions would have worldwide effects.
• Shortages in daily necessities could lead to public discontent and even political instability in some cases.

Policy reaction

• Central banks (including the Fed) may initially raise rates to address higher inflation. Over time, weaker growth—driven by shortages and reduced demand—could lead central banks to ease policy to limit business failures or prevent a housing downturn.
• Governments could expand fiscal support beyond fuel subsidies, including temporary cuts in taxes, fees, and charges to protect businesses and households.
• International coordination on energy and petrochemical supply may increase to balance distribution between “haves” and “have-nots.”

Market implications

• Stagflation concerns could drive a risk-off regime, pressuring both equities and bonds. There are few episodes to draw historical precedent from; Exhibit 1 shows the onset of the Russia-Ukraine conflict as Russian supplies of oil and gas were disrupted by sanctions, albeit this was a relatively short episode while the global economy was recovering from the pandemic.
• Historically, inflation-linked bonds outperform nominal government bonds during times of inflation shocks. The government bond curve could bullish flatten as growth momentum slows.
• Credit spreads would likely widen as weak growth raises default risk; high yield (ex-energy) would be more vulnerable.
• Within equities, energy and utilities have historically been more resilient in supply-driven energy shocks, while industrials, consumer discretionary, and technology may face greater headwinds amid higher yields and a cut back in consumption.
• Risk aversion typically supports a stronger U.S. dollar as investors favor liquidity.
• Gold has often performed well in rising-oil environments, though results have been inconsistent.
• Alternatives with long/short strategies (e.g., hedge funds) and income-generating real assets (e.g., transportation-related assets) may provide some resilience.
  

Re-escalation of military conflict across the region

Backdrop

The ceasefire breaks down and Iran resumes attacks on other Gulf states, focusing on energy production and processing facilities and transportation infrastructure. This results in a prolonged reduction in supply.

Economic reaction

• Damage to Middle East energy production and refining capacity removes supply from the market for an extended period. For example, if a major facility were damaged (e.g., a gas-to-liquids plant in Qatar), liquefied natural gas (LNG) output could decline materially for several years.
• The overall economic impact depends on the scale of the damage and the time required for repairs and reconstruction. This scenario assumes losses are not fully offset by spare capacity elsewhere and that restoring production takes at least 2–3 years.
• Energy prices would likely rise more sharply, and long-dated energy futures could also increase.
• Higher prices would weigh on activity and consumption, partially limiting further price increases over time.
• Demand destruction would resemble the extended-closure scenario, but governments and businesses may move more urgently to find alternatives. Renewable energy would be a natural path—especially in Europe and other developed economies. Some emerging markets (e.g., India) could expand coal use for power generation. Adjusting industrial processes to reduce reliance on petrochemicals may take longer.

Policy reaction

• Central banks are likely to prioritize growth and the functioning of the financial system, including providing liquidity as needed. The Fed could cut rates and potentially reintroduce asset purchases (quantitative easing), though willingness to expand the balance sheet may depend on the Fed’s leadership and policy stance.
• Balance-sheet expansion could also limit excessive increases in government bond yields if governments run large deficits to support the economy (similar to the pandemic period).
• Governments may need to significantly step up fiscal support through tax cuts and higher spending. Some support would occur automatically through built-in stabilizers (e.g., unemployment benefits).
• Some governments may also increase investment in the energy transition described above.

Market implications

• Fixed income volatility could rise sharply as markets try to price a policy path that balances inflation risks against recession risks. If central banks re-engage in quantitative easing, declining yields would favor outright long-duration positioning.
• Initial risk-off sentiment could trigger an equity correction, but aggressive policy support could prompt a rebound (COVID-19 in 1H 2020 is a relevant reference point for the policy impulse).
• Sustained supply disruption could shift investor focus toward beneficiaries of energy-independence policies: non-fossil fuels (solar, wind, hydro, nuclear), battery storage, infrastructure to reroute supply chains, and electric vehicles.
• This investment-cycle shift could increase demand for transportation and related infrastructure, creating opportunities for investors with longer time horizons and lower liquidity needs.
  

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