What We Think

The biggest story for markets in the past three years has been the impact of a rapid evolution of new artificial intelligence (AI) tools. However, the most important driver for markets in the past three months has been the evolving conflict in the Middle East, which drove most of the 4% decline in stocks in the first quarter.

In most cases, geopolitical events such as the Iran conflict tend to drive short-term corrections in the market, followed by recovery. Still, the wide-ranging impact of the current conflict suggests evaluating two paths that may lie ahead for markets: a downside scenario defined by escalation and a recovery scenario driven by stability.

Downside risks: Escalation, oil, and inflation

Let’s begin with a review of a potential “downside” scenario and the economic risks tied to energy markets. With nearly 20% of global oil shipments flowing through the Strait of Hormuz, sustained disruptions would constrain supply and keep oil prices elevated—which, have already reached levels roughly double those seen at the start of the year.

Persistently high energy prices may push inflation higher across the globe and act as a tax on consumers. In response, central banks may decide to maintain high interest rates despite slowing growth. This combination—rising inflation and weakening demand—increases the risk of a global recession.

In such a scenario, non-U.S. economies and equity markets, particularly in Europe and parts of Asia, may face greater challenges due to their heavy reliance on imported energy. While the U.S. economy and domestic stocks could also take a hit on higher energy prices, the U.S. position as a net energy exporter provides a critical buffer that did not exist during past oil-driven economic shocks.

Recovery scenario: History vs. uncertainty

While the bear case remains a real possibility, it is important to remember that markets have weathered past oil shocks and recessions. Periods of high uncertainty and volatility are challenging for investors, but history suggests that markets tend to eventually turn away from geopolitics and towards long-term earnings growth, ultimately driving total returns.

So, what could fuel a sentiment shift toward an upside scenario? First and foremost, a de-escalation of tensions and a resumption of normal shipping in the Middle East may increase oil supplies and ease inflationary pressures.

Lower inflation would reduce the need for aggressive central bank policy, allowing the modest economic growth seen in recent quarters to continue. Increased visibility and confidence would likely encourage businesses to resume capital investment, supporting earnings growth and equity markets. While this more favorable scenario may appear overly optimistic given recent headlines, we could see reality fall somewhere between the two paths we’ve outlined.

AI, tariffs, and the Fed

While the Iran conflict has captured the current market narrative, we are also monitoring other developments that are impacting the economy and investor sentiment. Within the tech sector, we are seeing a divergence between software stocks, struggling under the weight of potential AI disruption, and semiconductor companies, growing as they power the AI expansion.

Moving to the broader economy, we continue to see tariff policy evolve, though our sense is that many companies have already demonstrated an ability to adapt supply chains to shifting trade policies, suggesting these risks are more manageable than a sudden energy shock. Later this quarter we will have a new Federal Reserve Board Chairman. Turnover may bring a different approach to monetary policy just as the Iran conflict sparks fears of inflation, which may require higher interest rates—a concept that would have seemed farfetched as we entered the new year.

Positioning: Challenges and opportunities

Current geopolitical tensions have created challenges for stocks. We see both risk and reward, as rapid earnings growth in the U.S., along with recent volatility, has brought valuations down to more attractive levels. International equities also offer diversification and a valuation discount relative to the U.S., although earnings outside the U.S. are growing a bit more slowly. Meanwhile, inflation worries continue to boost bond yields, suggesting slightly higher long-term returns and potential for new opportunities for bond investors.

As we weigh the two paths ahead for the economy and markets, we continue to monitor developments, evaluate scenarios, and position portfolios to balance risk and opportunity. While the fog of war increases uncertainty for investors, we take a longer-term strategic view and favor owning the debt and equity of high-quality companies with durable growth as the preferred approach to compounding wealth.

We wish you all a happy spring.

Michael Bailey, CFA
Director of Research

Michael Mussio, CFA, CFP®
President

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