Conflict leaves markets at a crossroads

With the war between the US and Iran entering its seventh week, we’re close to an important crossroads for markets.

In the last several days we’ve had a ceasefire agreement, the highest-level diplomatic meetings between the two nations since the 1979 Iranian revolution, and US moves to blockade the Strait of Hormuz after talks failed.

The situation remains serious and extremely fragile, and oil has still spent much of the past week above US$100 a barrel.

With some 10-15 per cent of global production trapped, it’s no exaggeration to say this is creating the largest supply disruption in the history of the oil market.

We’re already seeing the impact of this across the global economy.

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The US inflation rate jumped to a two-year high in March, while consumer sentiment has plummeted to the lowest in the 74-year history of the University of Michigan survey.

Here in New Zealand, the Reserve Bank has suggested inflation could hit 4.2 per cent in the June quarter, well above previous expectations.

The Bank is keeping its options open, but if the oil price spike turns into broader inflation it’ll have little choice but to increase the OCR.

Financial markets have already moved to expect three hikes this year, starting in July and taking the OCR to 3.0 per cent by Christmas.

That’s not a given, but it’s certainly possible.

With all of that in mind, financial markets haven’t reacted as badly as some might’ve expected.

If you’d looked at your KiwiSaver balance at the beginning of the year and ignored it until today, you might think we’ve had a fairly dull year.

Yes, it’s been volatile at times, with the S&P 500 in the US down 9.1 per cent from its peak at its weakest point.

However, it’s rebounded strongly and is now just 1.3 per cent below its all-time high from February.

World shares overall are up in 2026, while US Treasury bonds and New Zealand corporate bonds are flat.

Even the VIX index (which is thought of as Wall Street’s “fear gauge”) last week fell back to its pre-conflict levels.

The point of “peak fear” looks to be behind us, or maybe investors expect incentives and constraints on both sides to ultimately lead to compromise.

The US would like a resolution for political and economic reasons, while Iran wants to keep its regime intact.

China, Iran’s largest trading partner and the purchaser of 90 per cent of its oil exports, is strongly in favour of a de-escalation too.

Here’s hoping Beijing’s influence could push things in the right direction.

One positive catalyst for global shares could be the reporting season, which ramps up this week.

Analysts are expecting year-on-year earnings growth for the S&P 500 of almost 13 per cent.

Its 30 per cent plus weighting to technology might also be in its favour.

The tech sector is down almost ten per cent from its October highs, while its earnings growth prospects remain healthy and it’s less sensitive to energy costs than others.

Bond and fixed income markets are at a more interesting juncture.

Investors have been noticeably cautious about these conservative assets throughout the conflict, unsure if they’ll prove a safe place to be or not.

While the prospect of higher inflation is bad for bonds, a weaker growth outlook typically means they’ll do well.

This caution could be because 2022 is still fresh in our minds, and we’re worried about a repeat performance.

That was the worst year in decades for bonds, as high inflation saw central banks crank up policy interest rates despite sluggish growth.

It’s true that central banks are often fighting the last war, but Jerome Powell’s term as Federal Reserve Chair ends next month.

We should have Kevin Warsh on board very soon to replace him, and he won’t have the same pandemic-era baggage.

Warsh might be more attuned to the growth side of the Fed’s mandate, and more inclined to reduce interest rates in the face of weakness.

For those picking this will all blow over soon, bonds and fixed income might look interesting at these levels.

We could be in for more volatility over the near-term, as the standoff continues.

If tensions ease and oil prices fall, the sharp rebound from early April will be back on and patient share investors will be rewarded.

If the disruption persists and inflation forces some central banks to tighten into a weaker economy, we’re looking at something much uglier.

It’s difficult to know which path we’re on, although the lack of panic in financial markets suggests it’s the one we’re all hoping for.

However, it’s still uncomfortable to be faced with two distinct outcomes with little middle ground on offer.

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