Key Takeaways:
Last Friday, June 13, Israel attacked Iran’s nuclear and military assets, widening the conflict in the Middle East. To put this into context, we offer the following points:
Previous hostilities between Israel and Iran did not lead to a wider conflict. Such appears to be the “best case” outcome for the current situation, although the level of intensity is a notable increase from the “tit-for-tat” scrimmages that have been ongoing for the past 14+ months.
A protracted, expanded war that draws in the US and others would be a “worst case” outcome, and the larger economic and/or market impact will depend on the scope and duration of the war. Trade-related stresses, supply chain challenges, and additional stagflationary impulses are all possible consequences.
Federal Reserve (Fed) policy is further complicated by this conflict. Additional upward pressure on inflation would make it difficult for the Fed to cut rates. The current fed funds rate is the target range of 4.25% to 4.50%.
Three possible scenarios from the conflict in the Middle East could possibly ensue.
Scenario 1 – conflict remains mostly limited to Israel and Iran: the spike in oil prices abates and does not affect global inflation on a long-term basis; risk assets face short-term downside volatility but recover once it becomes clear the conflict remains contained.
Scenario 2 – prolonged disruption to the energy complex: Iran restricts important trade access and targets US assets; oil pushes to $90/barrel or higher, posing an additional stagflationary shock; market reaction would depend on duration of energy disruptions and/or actions taken to lessen the impact (including potential release of strategic reserves); risk assets would suffer, and safe haven assets would fare best.
Scenario 3 – rapid escalation, quick recovery: US is also drawn into the conflict but, in this scenario, a more severe attack leads to a more punishing response and Iranian capabilities are quickly dismantled; sharp market decline followed by sharp recovery; longer-term uncertainty over the Middle East would persist, however.
Bottom line – how to invest now.
Typically, geopolitical events are short-lived. Typically, other forces such as monetary policy, the health of the labor market, the outlook for inflation, etc., play a larger role on market returns. Last Friday’s market reaction did not show panic. Volatility rose, but did not spike, and inflation expectations remained stable.
Real assets, such as gold and energy stocks, provided important diversification last week – we continue to recommend real assets in client portfolios. Treasuries have been less effective at offering diversification but could be additive if things worsen materially.
When volatility is low, investors should preserve capital. When volatility is high, investors should deploy capital. We continue to watch implied volatility (VIX) and other sentiment indicators for moments to put incremental capital to work. We will continue to highlight these if/when such opportunities present themselves (for examples, please refer to our National Client Call on April 9, 2025).
We continue to believe non-US equities should represent approximately 30% of a total portfolio’s equity exposure. Non-US equities can also help hedge against a falling US dollar.
During last week’s volatility, the US dollar did not fulfill its traditional safe haven role. Further dollar weakness appears likely, highlighting the need for diversification as noted above.
Equity Takeaways:
Global equities rose in early Monday trading. The S&P 500 rose approximately 0.9%, to 6028, while small caps rose a similar amount. International shares were also higher.
Last Friday, the S&P 500 fell a bit over 1%, but there was little panic signified within market internals. Implied volatility (VIX) reached 21, slightly above average, but well below panic levels. For context, during the sharp selloff earlier this year, the VIX crested above 50.
Crude oil prices have been slowly declining since mid-2023. Last week’s rally in oil prices brought us back into the middle of a long-standing trading range. Eventually, we believe crude oil prices will bottom and begin moving higher, but this is a long-term call.
Thus far in this conflict, Israel has attacked Iranian natural gas fields (largely used domestically within Iran) but have largely avoided Iran’s oil export infrastructure. Early in the conflict, Israel appears to be focusing on disrupting Iran’s domestic economy, not their oil exports, further lending support to the argument that this is largely a regional dispute versus something much larger.
The earnings weighting of the energy sector in the S&P 500 is approximately 10%, but the energy sector only comprises approximately 3% of total S&P 500 market capitalization. In other words, the sector has a lot of earnings power relative to its market capitalization.
Investors are unwilling to place a high multiple on energy sector earnings due to negative long-term perceptions around the sector. We believe the gap between energy sector earnings power and market capitalization is likely to close with higher energy stock prices down the road.
Fixed-Income Takeaways:
Treasury yields rose 5-10 basis points across the curve last Friday (June 13) in response to Israel’s attack on Iran. Oil prices rose approximately 8% on the day. Bond investors are likely concerned about rising oil prices and their potential impact on inflation. All else equal, upward pressure on oil prices could push inflation higher, which would put upward pressure on bond yields.
In early Monday trading, yields were essentially unchanged. Overall, 2-year Treasuries were yielding 3.95%, 5-year Treasuries 4.01%, 10-year Treasuries 4.41%, and 30-year Treasuries 4.90%.
A prolonged, wide-ranging conflict in the Middle East could ultimately push investors into safe haven assets, such as Treasuries, which would push yields lower. Such a scenario is not our base case.