Global financial markets are entering the second quarter under heavy influence from headlines about the Middle East, with investors increasingly focused on the potential economic and market fallout of the conflict. The recent shock to energy supplies and the sharp rise in oil prices have altered expectations for inflation and monetary policy, creating a backdrop that could either deepen equity market losses or, if the conflict endures and growth concerns outweigh inflation worries, support a rebound in bond markets.
Oil prices have been the dominant market mover. Over the past quarter the commodity has surged roughly 90 percent to trade above $100 a barrel, a move that has forced investors to revise higher their expectations for interest rates. Analysts polled by Reuters who assessed the current supply disruptions put oil forecasts between $100 and $190, with an average projection of $134.62, conditional on those disruptions remaining in place.
Market odds compiled on an online prediction market put the probability of the war ending by mid-May at about 36 percent and at roughly 60 percent by the end of June, underscoring that many investors still view the conflict as unresolved in the near term.
In fixed income, the price reaction has been immediate and severe. Short-dated borrowing costs in Britain and Italy have climbed about 75 basis points each this quarter, while moves in U.S., German and Japanese government bond markets have also been notable. As yields have surged and prices fallen, investors have re-priced the path of policy rates: markets have largely taken U.S. rate cuts out of the picture for this year, priced in three hikes for the euro area and at least two in Britain, and effectively put a brake on an emerging markets easing cycle that many had expected.
"It’s difficult to look through the noise when the noise is all we have," said Seema Shah, chief global strategist at Principal Asset Management, which oversees roughly $594 billion. "We’ve been pushing towards international (stocks) exposure and that continues to make sense, but it doesn’t mean you close off your exposure to the U.S."
Several strategists highlight two central elements that will determine market direction from here: how long the energy shock lasts, and how central banks respond. "In all the historical oil shocks, only two things matter: one, the duration of the shock and second, the central bank reaction, which defines the broader risk appetite," said Manish Kabra, a multi-asset strategist at Societe Generale.
Kabra has already adjusted positioning to reflect that assessment, raising commodity allocation to 15 percent from 10 percent after the conflict began, a move he said mirrors the growing link between geopolitics and commodity markets. He also pointed to the U.S. Memorial Day weekend in late May as a potential focal point for market attention, with the start of a peak travel season possibly amplifying consumer pressure on policymakers to restrain energy costs.
Despite the sharp move higher in yields, some fixed income managers now see value if the crisis eases. Francesco Sandrini, head of multi-asset strategies at Amundi, said the firm has increased holdings of short-term euro zone government bonds and maintained exposure to five-year U.S. Treasuries on the view that fixed income could perform when the acute phase of the crisis passes. "In other words, we expect central banks will try to look through short-term price pressure," Sandrini said.
Similarly, Paul Eitelman, global chief investment strategist at Russell Investments, said bonds appear more attractive than they did a few months ago and suggested that the recent strengthening of the U.S. dollar - a roughly 2 percent rally in March as investors sought safety - may not persist over the medium term. Before the war some investors had diversified away from U.S. assets, weighing on the dollar; analysts say that dynamic could re-emerge if the conflict is resolved.
Commodity and safe-haven markets have also moved sharply. Gold, which often benefits from inflation worries, has eased about 4 percent in March as investors liquidate profitable positions to cover losses elsewhere.
Equities have held up better than some other assets so far, supported by strong corporate earnings and momentum in technology, but selling pressure has increased. The S&P 500 and Europe’s STOXX 600 sit about 9-10 percent below recent record peaks, while Japan’s Nikkei has declined almost 13 percent from its February record high. In response to the darker outlook, Zurich Insurance Group’s chief market strategist Guy Miller said he had shifted to an underweight position on equities from a prior overweight stance.
Forward-looking business indicators and sentiment measures have weakened. U.S. consumer sentiment fell by more than expected in March, German investor morale has deteriorated significantly, and S&P Global’s March Purchasing Managers’ Indexes for both the euro zone and the United States moved to multi-month lows - all signs of cooling activity.
While the United States benefits from a relatively strong economy and its role as an energy exporter, analysts still expect it to be affected if high energy costs persist. The Organisation for Economic Co-operation and Development has warned that the global economy has been pushed off a stronger growth path, reflecting the broader drag from increased energy prices and geopolitical uncertainty.
Zurich’s Miller said this episode stands apart from other geopolitical and political surprises of the past year because, unlike those earlier shocks, it has had a meaningful impact on earnings, corporate margins and market multiples.
Implications for investors and markets
- Higher oil prices and sustained supply disruption are central risks for global growth and inflation, with knock-on effects for bond yields and central bank policy decisions.
- Fixed income could prove attractive if the acute phase of the crisis ends and central banks look through short-term price pressures; some managers have already repositioned toward short-dated government debt and intermediate Treasuries.
- Equities remain vulnerable to further downside in the event of prolonged geopolitical disruption, despite the cushioning effect of strong earnings and technology sector strength to date.