It is plausible that political reasoning does not coincide with economic reasoning.
The geopolitical crisis in the Middle East is the latest in a list of political events that investors have been bombarded with in recent years. This appears to be affecting household savings behaviour. European households are more reluctant to spend than before the pandemic and are therefore amassing vast war chests of savings (see Exhibit 27). And, perhaps due to the constant barrage of political headlines, households are keeping a large proportion of these additional savings in cash.
The opportunity cost of fear is, however, starting to prove sizeable. Higher rates of inflation are eroding the value of the cash on deposit, leaving a large loss relative to the purchasing power had the savings been invested (see Exhibit 28).
Nevertheless, the risks investors cite are understandable. We highlight two key risks and how investors can be invested, but with some protection against them.
The Strait remains closed
The risk: The main risk to our base case scenario concerns the evolution of the geopolitical crisis between the US and Iran. In the recent past, negotiations have repeatedly come close to an agreement, only to collapse at the last moment. There are four particularly tricky aspects of the negotiation. Iran wants to have: some medium-term control over the Strait of Hormuz, potentially collecting tolls from passing vessels; sanctioned Iranian assets to be unfrozen; and reassurance of no further attacks from Israel on Lebanon. The US wants assurances that Iran will end its nuclear capability.
In our core scenario the Strait will open with many of these details left to be resolved at a later date, simply because it’s too costly for either the US or Iran to be the cause of a global recession. However, it is plausible that political reasoning does not coincide with economic reasoning.
A prolonged crisis should, therefore, be treated as a key risk, including the possibility that the Strait remains closed for an extended period. This situation could lead to an oil supply shortage, potentially pushing oil prices above USD 150 per barrel. In this environment, both the consumer and business engines of growth would be affected, likely leading to an outright global recession.
With midterm elections approaching, the US government could introduce additional fiscal stimulus measures to mitigate the negative impact of higher gasoline prices. This action could limit the growth slowdown but with negative implications for the already high deficit-to-GDP ratio, which may unsettle government bond markets.
European activity could be more at risk given the region’s energy vulnerability. The European Commission appears inclined to allow only limited flexibility for member states to implement support measures for consumers hit by higher energy costs, although this tone may soften in an extreme scenario. The energy and geopolitical crisis could increase pressure on European governments to step up investment in infrastructure, security and defence, though implementation timelines would likely be long. Asia could also be vulnerable, given many countries’ high dependence on energy imports. This could translate into deteriorating trade balances, lower foreign currency reserves and weaker currencies.
While global growth would slow, inflation would rise, resulting in a stagflationary scenario. At that point, central banks would face a difficult trade-off: raise rates to fight inflation or stay on hold to avoid further damaging growth. With inflation already above target for some years now, central banks may lean towards tighter policy to prevent inflation expectations from de-anchoring and to avoid repeating the mistakes made in 2022, when delayed tightening contributed to an acute inflation episode.
The markets: A prolonged closure of the Strait is a challenging backdrop for both stock and bond markets. In equities, energy importers and rate-sensitive sectors are likely to be hit hardest. A more defensive, quality-focused strategy would be the most appropriate choice to help mitigate the impact of an equity market drawdown. It is unclear whether global technology would prove defensive in this environment. The ongoing scarcity of growth could lead global capital to crowd into this area of the equity market. However, rising inflation and fiscal support that leads to higher long-term bond yields could challenge growth stocks, particularly given that a likely fall in business investment would further hinder tech stocks’ ability to demonstrate return on their investment.
In an acute inflation shock, commodities would perform well and real assets, such as timber and core infrastructure, would likely offer a strong hedge. In a chronic inflation scenario, gold could also play an important diversifying role, albeit with potentially elevated volatility.
Tech euphoria fades
The risk: A strong first quarter earnings season for tech has revived investor appetite, but positioning has been selective, favouring AI supply chain component makers and exposure to emerging markets, particularly South Korea and Taiwan. The key risk is that AI sentiment weakens if demand for AI infrastructure proves overstated; the main trigger could be signs of slowing demand from some of the highest-profile model providers, or perhaps more sceptical tones from the broader CEO universe. Any signs of more modest demand for AI than is currently baked into expectations would feed concerns about excess capacity, lower prices and margin compression. US growth would slow as AI capex stalls and a negative wealth effect for US households could be detrimental to US consumer spending.
Markets: This scenario would be negative for equities, particularly in the US and emerging Asia. Europe’s relative lack of technology would turn from a perceived weakness to a perceived strength. Defensive stocks would likely outperform cyclicals. Concerns would intensify around private equity and private credit, given their technology exposure.
In this scenario we would expect core fixed income to provide valuable insurance as the correlation between equities and bonds would turn negative again. High-quality, long-duration fixed income could provide meaningful upside. If the 10-year US Treasury yield fell 200 bps, which would be likely in a recession scenario, this would represent a 20% return over 12 months.
It’s not all downside, there is an upside risk that is not priced
The risk: There is a scenario whereby a rapid resolution to the conflict in the Middle East coincides with meaningfully lower energy prices next year as the structural damage to OPEC affects oil producers’ behaviour. Each major producer would try to extract as much value as possible from their remaining oil assets, providing a major growth tailwind. It is also possible that as companies adapt to new technologies and realise the productivity gains, we will see a much greater uplift in corporate earnings across the broader universe. The combination of these two possibilities would create a “goldilocks” scenario with positive momentum into 2027.
Markets: We would expect this environment to be very constructive for global risk assets. Investors sitting on cash should be aware that markets aren’t quite priced for perfection.