Analysis suggests that markets are underestimating the supply disruption caused by potential interruptions to oil transit through the Strait of Hormuz. This crisis has already significantly driven up prices for most commodities and appears difficult to resolve in the short term. What was initially perceived as a temporary geopolitical event has evolved into a genuine supply shock. The crisis introduces stagflation risks: it elevates overall inflation rates while simultaneously suppressing demand, as households increase spending on essentials like heating and reduce discretionary purchases. This combination is detrimental for markets, raising the likelihood of concurrent sell-offs in both bonds and equities. For stocks, this translates to higher input costs and a reduced ability to pass these costs on to consumers, leading to compressed profit margins. This situation is exacerbated by rising yields driven by inflation and a corresponding hawkish pivot from central banks. A strengthening US dollar further amplifies these effects, particularly for energy-importing nations and emerging markets.
To assess potential market volatility stemming from the Iran conflict, a recent study analyzed the relationship between asset prices and commodities during four past supply shocks: the 1973 oil embargo, the 1979 Iranian Revolution, the 1990 Kuwait war, and the 2022 Russia-Ukraine war. Based on the current trajectory of the BCOM commodity index, historical beta coefficients indicate that the required market adjustment is significantly larger than what is currently priced in. Valuation gaps for many assets appear substantial. Relative to the movement in BCOM, US breakeven yields, UK yields, and precious metals seem undervalued. Equity prices in most regions, except for the US and Latin America, do not appear to fully reflect the downside risks, with emerging markets facing the greatest exposure. These regional disparities reflect the fact that Asian and European economies are primarily energy importers, whereas the US and Latin America are energy exporters.
Naturally, structural differences exist compared to previous episodes. Most notably, the US became a net energy exporter in 2019, reversing the relationship between the US dollar and commodity prices. The dollar now benefits from both safe-haven demand and improved terms of trade. However, the average beta values shown are skewed by the US's status as an energy importer during the first three events, resulting in a negative beta. Examining the impact of the Russia-Ukraine war more directly, Brent crude prices rose approximately 32% from the invasion's start to their peak over three months later. The US Dollar Spot Index initially reacted with a lag as the market assessed the economic implications, but ultimately rose 15% over several months. In the current conflict, Brent prices have increased about 56% since the war began, yet the Dollar Index has risen just over 2%.
Regional factors are also critical. In 2022, European equities were most sensitive to rising energy prices due to their direct reliance on Russian energy; in 1990, Asia was more significantly affected. Today, Asia's greater dependence on commodity shipments transiting the Strait of Hormuz suggests its downside risk is potentially larger. Regarding interest rates, the US 10-year Treasury yield rose during all four historical periods, although the beta coefficients varied significantly. Available data show that breakeven yields tend to rise sharply with accelerating inflation, while real yields reflect the balance between slowing economic growth and expectations for tighter policy. Policy responses corroborate this pattern. During these events, the Federal Reserve never cut rates; it actually hiked rates in three instances and paused easing during a cycle in 1990. Fiscal policy might offer some short-term support for economic growth and equities, but given that most developed economies already face deficit pressures, such policy would likely coincide with rising yields, limiting its positive impact on risk assets.
Markets seem reluctant to fully price in the negative consequences of rising energy costs. As Simon White notes, commodity investors might be more pessimistic about geopolitical risks than financial asset investors. Although market sentiment has weakened recently due to attacks on energy infrastructure, the forward curve still reflects expectations for lower future energy prices. This creates a clear contradiction. Either commodity prices will fall, validating the current market pricing, or the macroeconomic impact will begin to manifest in the data. In the latter scenario, both bonds and equities would be at risk, whether through sharp price adjustments triggered by adverse news or a more gradual repricing as expectations shift.
