The Middle East conflict, while first and foremost a human tragedy, also represents an energy supply shock with potentially significant implications for global growth. In a new paper, Head of Global Sovereign, Inflation and Rates, Cedric Scholtes presents a framework for analysing the war’s fixed income investment implications.
Currently, financial markets remain on edge, uncertain as to the magnitude and duration of production and supply disruptions in the coming weeks, which will determine the path for energy prices, with implications for inflation and growth.
Dealing with this level of uncertainty can be challenging for investors, but our macroeconomic research team has developed three scenarios for energy prices, which are used to draw out implications for likely policy responses. These three scenarios are:
- A baseline scenario in which the conflict is relatively short-lived
- An escalation scenario, where the conflict timeline is extended and / or regional energy infrastructure is damaged, generating a sustained period of supply disruptions and elevated prices lasting for months
- A de-escalation scenario in which oil prices would quickly return to pre-conflict levels.
But there is also a possible fourth scenario, where the war escalates to such a degree that Middle East energy extraction, refining and distribution facilities become so comprehensively damaged that at least a third of the region’s energy output would be offline for months, if not years.
In each case the macroeconomic research team models the scenarios’ various implications for growth, inflation and policy rates.
This analysis was completed before President Donald Trump announced on 12 April a US Navy blockade of the Strait of Hormuz. The scenarios presented however remain applicable in terms of providing a framework for analysing the investment implications of the different scenarios envisaged.
Outlook for second quarter 2026
The key driver of financial markets (over the short term) remains the developments in the Middle East – and most importantly the outlook for production, refining and distribution of crude oil, distillates, natural gas and derivatives like fertilizers and helium, which will drive the path of prices.
Over the last few weeks we have considered prospects for 3 main scenarios for the Iran conflict:
- A surgical strike focused on leadership, military and nuclear program targets, that might last perhaps a couple of weeks;
- An extended war of 4 to 6 weeks aimed at eradication of key leadership ranks, comprehensive destruction of conventional military and nuclear enrichment and weapons capabilities, with the possibility of formenting a popular uprising or outright regime change, in which energy infrastructure is only minimally affected and the Straits of Hormuz are only temporarily restricted– broadly in line with our Research Team’s Baseline scenario ;
- An Escalation trap scenario where the United States gets sucked into a quagmire lasting many months, with the Iran regime proving resilient to US and Israeli airstrikes and able to retaliate via asymmetric means to attack regional energy infrastructure and close or heavily restrict transit through the Straits of Hormuz – broadly in line with the Macro Research Team’s Escalation scenario.
It was quickly apparent that Scenario 1 was not in the cards. Investors then focused on assigning probabilities between the Baseline Scenario (in which the energy shock is temporary) and the Escalation scenario (in which the energy shock is large and persistent). It is our view that Iran is capable and willing to entertain the Escalation scenario and is has the incentive to exercise its main source of leverage – control of the Straits of Hormuz (SoH) – to extract concessions in any peace negotiations and dissuade further attacks. Nevertheless, the recent bilateral announcement of a 2-week ceasefire – if taken at face value – suggests a desire by both parties, but the Trump administration especially, to find an off-ramp to the conflict.
My interpretation is that, in threatening to “destroy Iran’s civilization” if it did not reopen the Straits of Hormuz, President Trump was using his usual negotiating approach of ‘escalate to de-escalate’, but even he realized that delivering on a threat to wipe out Iran was not realistic. Nuclear strikes on Iran were inconceivable, and destroying civilian infrastructure would be a war crime and would prompt refusals from his own military, as well as domestic political backlash and possible calls for his removal from office via Article 25. My interpretation is that Trump blinked first. At the same time, Iran has made its point that it has leverage via control the SoH, if not legal sovereignty – so the question is whether there would be an advantage to keeping this going much longer? (Yes, if it would lead to Trump’s removal via Art 25 or impeachment, but the midterms are a long way away…).
In any case, it is clear the search for an off-ramp is now the priority (though Israel’s ongoing strikes against Hezbollah in Lebanon are a potential block to a deal), even if it is unrealistic to expect energy flows through the Straits at pre-war levels any time soon. We have to assume that Trump is desperate for the off-ramp, and will find a compromise with the Iranians to turn this into a more permanent arrangement. But this is just a guess, as Trump’s psychological state is ‘volatile’. The official Iranian demands (reparations, repeal of sanctions, right to enrichment, control of SoH), meanwhile, are probably largely a public relations exercise to signal that they are the aggrieved party, and more realistically they would accept to reopen the SoH as long as economic sanctions were eased. If Iran agreed to IAEA oversight of any enrichment and agreed to stop or limit support for the Houthis & Hezbollah, one could envisage the US praising commitments from the regime and removing sanctions. Obviously, much of this is speculation – but such is the way in the Trump era.
We are therefore more constructive, but markets have already repriced. And, as we have noted, Iran is willing to pursue the Escalation scenario.
So what to do in bond portfolios? If the 2-week ceasefire, despite its implementation and sabotage risks, signals a mutual desire to see a resolution to the conflict, then it marks the beginning of the end of this period of market stress. The probability of a low growth / high inflation Stagflation scenario would recede, to be replaced by a scenario in which the energy shock is significant but temporary. If the ceasefire takes effect and leads to a successful resolution of the conflict, we are in a Baseline scenario, so energy prices should be capped and falling, the hit to growth and inflation is modest and transitory, risk assets should perform, volatility should decline. A temporary energy shock allows central banks to ‘look through’ a one-off increase in prices, avoiding a large tightening of policy. Breakeven inflation rates should narrow and real yields should compress amid less restrictive policy rates and reduced focus on fiscal stress. Market focus would return to a soft labor market and stress in private credit markets, both of which would argue for lower real yields.
A Stagflation scenario triggered by persistently high energy prices becomes especially concerning when inflation is aggravated by a large fiscal response, which forces the central bank to raise rates, which can feed back into deficit and debt sustainability concerns that can drive real yields sharply higher in a negative feedback loop. Our view, at time of writing, is that Iran and The US will work towards a compromise to sign a truce with Iran. We are inclined to increase our exposure to interest rate riskt, expressed via 5y5y forward US inflation-linked bonds (yields currently at 2.63%) and 30y spot US inflation-linked bonds (yields currently at 2.69%). We would also reduce our exposure to breakeven spreads in 10 and 30-year maturities. The risk to this strategy is that the Iran conflict re-escalates, driving energy prices higher, and the US administration pushes for a significant fiscal expansion ahead of the mid-terms, which would once again pressure real yields higher.
Read the full paper here: Potential implications of the Middle East conflict for bonds.
