The fog of war remains thick, which makes any analysis of the ongoing Strait of Hormuz Crisis difficult. Both sides keep threatening each other, only to retreat afterward. President Trump offered to de-escalate the conflict in the Middle East after saying that regime change had already been achieved, that negotiations with Tehran were progressing, and that he was pausing his threat to target Iranian energy infrastructure for ten days. Then he reversed course and gave Iran a deadline of 8 pm Tuesday Eastern time to reopen the Strait of Hormuz or be bombed into the Stone Age. And with one hour to go, he reversed course again, agreeing to a 2-week ceasefire to continue talks. In each case, markets reacted strongly, with oil falling more than 10% in immediate response to Truth Social posts and government press releases.
What should markets make of this whipsaw and current turnaround? First, we can ignore any commentary from Iran. There has been no confirmation from leadership in Tehran of ongoing talks. Instead of listening to Tehran’s words, investors need to be watching its actions.
Even with another extension, the Strait of Hormuz question will remain unresolved, and attacks on GCC energy infrastructure will likely continue, with repercussions rippling through the global economy over the next few months. Iran and the US face different constraints. Iran will not risk total destruction of its civilian infrastructure, as discontent toward the regime was already elevated before the war.
For now, Iran has agreed to open the Strait of Hormuz during the ceasefire, suggesting it is open to de-escalation. However, this situation is highly unpredictable as President Trump continues to raise new threats to put pressure on Iran to make a deal.
Obviously, the current situation is not a good one for President Trump politically. As most Americans do not see the benefit of a war with Iran, and the only noticeable effect is much higher gas prices, which are affecting mostly working Americans. So, President Trump has a strong incentive to find some sort of solution to this conflict before the summer, otherwise the impact on the mid-term elections could be significant.
Recent headlines have raised hopes of a de-escalation in the Middle East, but the facts on the ground remain mixed. In recent weeks, Tehran and Washington have exchanged a cacophony of statements, some suggesting rising odds of de-escalation. At the same time, military attacks have continued. Iran targeted a Kuwaiti tanker off the coast of the UAE, then a Qatari tanker off Doha, while the U.S. intensified attacks on Iranian industrial capacity.
So why are hopes for de-escalation raised? First, it is important to note that shipping through Hormuz has picked up. Second, Iran is deliberately shifting away from GCC targets toward Israeli ones. Iran treated Israel and its GCC neighbors as equal opponents in the first days of the war. That is no longer the case, with Israel now bearing the brunt of the attacks, despite the attacks on GCC tankers. Third, the U.S. has not yet taken the “gloves off” in this conflict. Israeli strikes continue to outpace US ones by a factor of 3-4x each day. The U.S. can still intensify the punitive air campaign, or, as President Trump said at the start of the conflict, unleash “death, fire, and fury.”
What is important to keep in mind is that markets will not start to recover only when there is a “truce” or “peace”. Markets react to an improvement in the rate of change. There is a long history of Middle East military conflict, finding an acceptable equilibrium for the global economy and markets.
For Iran, closing Hormuz to all traffic is tricky as it hurts enemies and allies alike. Tehran depends on China for almost all the imports that make Iran a modern, industrial society. Its drones, while assembled in Iran, need Chinese semiconductors and electronics.
As such, we do not believe that Iran can completely ignore Trump’s offer to de-escalate. Yes, Iran can remain aggressive on many fronts, but the Strait of Hormuz is not one of them. If Trump halts the war, Iran will likely allow ships to pass.
This is not the first Strait of Hormuz crisis; it also happened during the 1980-1988 Iran-Iraq war. A geopolitical equilibrium could emerge in the region that includes continued military action, yet the markets could become desensitized to it if that equilibrium allows energy to transit through Hormuz. In a way, this would parallel what happened in 2022. The war between Ukraine and Russia continued, but markets moved on from that conflict from September 2022 onwards.
As such, we need to watch what is being targeted over the next few weeks. If Iran focuses mostly on Israeli and U.S. bases, eschews targeting Gulf state energy infrastructure, while showing willingness to allow vessels to transit through Hormuz, we could be in the early stages of such an equilibrium.
For the world, this could be an acceptable reality. The Israel-Iran conflict will be seen as a regional geopolitical conflict, where military tensions can continue to simmer. Risk assets will likely rally if there are signs that Hormuz is opening, even if the war continues.
- Oil Shock and Recession Risk
- Risk of AI Bust
- A Resilient U.S. Economy
- Volatile Equity Markets to Continue
- Rising Bond Yields
- A Stronger Dollar?
- Yen: Still Very Cheap
- $150 Oil
- Gold Did Not Protect
- Our Portfolio Positioning
Oil Shock and Recession Risk
The current macro environment is a tricky mix of vulnerabilities similar to those that caused past recessions. A combination of rising oil prices, an unsustainable tech capex boom, elevated equity valuations, high home prices, and signs of stress in private credit and other parts of the financial system.
Since the 1973 downturn, every U.S. recession, excluding the pandemic downturn, has been preceded by an oil shock. Although a lot can still change over the coming days and weeks, today’s oil shock is as bad as any of the previous ones. Even though Iran continues to export crude and some oil is making its way through pipelines to the Red Sea and the Gulf of Oman, about 12% of global oil supply is currently offline.
Higher oil prices damage the economy in three ways. First, they increase input costs for producers. If oil prices remain elevated, everything from the cost of plastics to the cost of fertilizer will rise. The price of urea, a fertilizer, has already risen 37% since the start of the war. Diesel and jet fuel prices have jumped, raising the cost of transportation
Second, higher oil prices reduce real incomes, leading to less spending on non-energy-related items. And third, higher oil prices could prompt central banks to raise interest rates to quell inflationary pressures.
Going into the war, the market expected 72 bps of Fed rate cuts over the next 12 months. Now, it is discounting 10 bps of hikes. However, we do not expect the Fed to hike rates. The Fed will likely still cut interest rates later this year, especially if Kevin Warsh takes over as Chairman.
Nevertheless, the odds of a global recession have increased. The ability of policymakers to respond to a downturn is constrained by high government debt and rising inflation.
Risk of AI Bust
The 2001 recession largely stemmed from a collapse in tech capex amid the bursting of the dotcom stock market bubble. There is a risk that something similar happens to AI. The issue is not so much around whether AI will prove to be transformative. It likely will. The issue, as in 2001, is whether all the recent capital investment will be successfully monetized.
The risk is that AI becomes like electricity. Access to electricity makes a company more efficient, but does not necessarily make it more profitable if all its competitors also have access to electricity. We have already seen these dynamics play out in the software space. A few months ago, the conventional wisdom was that AI would benefit software companies by allowing them to slash programming costs. That turned out to be true. But the problem was that AI also lowered programming costs for everyone else, including the customers of software companies. Investors began to rightfully fear that rather than buying expensive software, more companies would simply ask Claude to code something bespoke for them.
Admittedly, it is too early to call the end of the AI capex boom. GPU rental rates have risen over the past few months, as use of Agentic AI has soared. Memory chip prices remain at very high levels, and Nvidia’s order books are full.
A Resilient U.S. Economy
February U.S. retail sales showed a resilient consumer heading into the energy shock. Headline retail sales rose 0.6% m/m after contracting 0.1% a month prior. The core measure, excluding autos and gasoline, rose 0.4%.
March consumer sentiment has been fragile amid higher gasoline prices. While the Conference Board measure firmed, consumer expectations deteriorated and the labor market was near cycle lows.
Still, the US consumer could be resilient in the face of higher energy prices. While the labor market slowed in the past year, it has not collapsed. Additionally, spending on energy goods and services represents a historically small share of consumer spending, at less than 4%. Higher energy spending could still be a headwind to overall consumer spending by taking up a larger share of household outlays or by increasing precautionary savings.
The March ISM Manufacturing report showed continued expansion, but rising price pressures remain the more important signal. The index ticked up to 52.7 from 52.4, beating estimates and marking a third consecutive month in expansionary territory. Much of the increase came from longer delivery times, but even excluding that component, the index would still have remained in expansion, as production improved.
Manufacturers’ comments were negative, reflecting heightened geopolitical uncertainty. Activity has likely not been affected yet, but the energy shock has already weighed on both business and consumer confidence.
The Atlanta Fed GDPNow estimate for Q1 GDP growth has dropped from 3.2% at the end of February to 1.3% today. So, a clear indicator the U.S. economy is slowing.
The longer the Hormuz crisis drags on, the bigger the risk of a recession. So, how events will evolve in the coming weeks will be important for our longer-term outlook.
Volatile Equity Markets to Continue
In March, equity markets sold off amid the Iran war and sharply higher oil prices. However, the sell-off is still relatively limited. Since the start of the year, most markets have only been down a few percentage points. And that is after a strong equity market performance last year.
As we have seen before, the market’s outlook can change at any time, for better or worse, based on what the Trump administration says or does.
Stocks do look oversold in the near term. The forward P/E ratio for the S&P 500 has fallen from a high of 23.1 in late October to 19.5 at present. About one-third of the decline in the P/E ratio has been due to a drop in stock prices, with the rest attributable to a rise in forward earnings estimates.
In the coming weeks, companies will report Q1 earnings, and we expect them to remain quite strong. However, we also expect many companies to provide a more cautious outlook.
The fact that earnings estimates have continued to increase in the face of growing macroeconomic uncertainty is less reassuring than it might appear. Historically, earnings estimates have lagged broader macroeconomic developments. Perhaps even more importantly from an investment perspective, earnings estimates have also lagged stock prices.
At the moment, structural economic forces are still in favor of equity markets. But it all depends on whether the conflict escalates or drags on for a long time. One thing is for sure: markets will remain very nervous in the short term, as investors try to interpret any news as positive or negative. This means that volatility will continue, but it can generate moves in both positive and negative directions.
Rising Bond Yields
In the past month, Treasury yields have risen, mostly due to higher inflation expectations. This meant that bonds did not provide much protection against weakness in the equity market. We think long-term bonds will outperform later this year due to a slowing U.S. economy, even if the war with Iran is resolved relatively soon. Plus, we still think the Fed will continue to cut rates this year, despite higher short-term inflation because of the higher oil price. Despite the jump in oil prices, long-term market-based U.S. inflation expectations remain well anchored. Wage growth, which is the most important driver of services inflation, continues to cool. Real-time measures of job openings have moved sideways over the past few months but are likely to decline following the oil shock. As a measure of labor demand, job openings tend to lead wage growth. All this suggests that the Fed will be cutting rates later this year.
We continue to prefer government bonds over corporate bonds. Even though corporate credit spreads have widened over the past two months, they remain tight by historic standards. The corporate default rate would need to fall from 4.9% to 3.5% to justify the current level of spreads
A Stronger Dollar?
The dollar started the year with weakness, falling by 1.9% between the start of the year and January 29. But since then, the broad trade-weighted dollar has gained 2.3%. It is essentially flat for the year. As a net energy exporter, the U.S. trade balance benefits from higher oil prices. This stands in contrast to most other developed economies, except for Canada, Australia, and Norway. Nominal rate differentials have generally moved against the U.S. dollar over the past four weeks, as markets have priced in more monetary tightening abroad than in the U.S.
In contrast, real interest rate differentials have been supportive of the dollar because inflation expectations have risen more abroad. At least theoretically, real rate differentials should matter more for currencies than nominal differentials.
So far, at least, there is little evidence of safe-haven flows into the Treasury market. Adjusting for moves in short-term rate expectations, the 10-year yield has risen more in the U.S. than in the Euro Area, UK, Canada, or Australia. This suggests that if the oil shock fades, the dollar could start weakening again.
The long-term picture remains challenging for the dollar. The dollar remains overvalued based on Purchasing Power Parity (PPP) exchange rates. This remains the case even after adjusting for the fact that long-term real interest rate expectations are higher in the U.S. than abroad. The U.S. has been running current account deficits almost nonstop since 1982. This has resulted in a net international investment position, the difference between a country’s foreign assets and liabilities, of negative 90% of GDP. This is likely to weigh on the dollar over the coming years.
Yen: Still Very Cheap
Historically, the yen has traded as a risk-off currency. It even strengthened against the Swiss franc during the worst points of both the GFC and the Covid crash. Japan’s foreign assets exceed its liabilities by 86% of GDP. Japanese investors often repatriate their foreign holdings when they become more nervous.
The yen has remained weak during the oil shock because higher oil prices have reduced Japan’s terms of trade and also because interest rate expectations have risen more outside of Japan. Right now, the yen is a loaded spring. Based on its PPP exchange rate, it is 47% undervalued against the US dollar and 41% undervalued against the euro. If oil prices start to fall later this year, as attention shifts to weaker global growth and the prospect of monetary easing outside of Japan, the yen could strengthen significantly.
$150 Oil
It is impossible to know how high oil prices will reach in the near term. What is more certain, however, is that prices will fall over the long haul. The 5-year futures price for WTI crude basically tracks the breakeven cost for shale producers. Admittedly, the relationship between oil prices and costs is somewhat circular, in that higher prices incentivize drilling higher-cost wells. Nevertheless, given the abundance of shale oil in the U.S. and some other countries, it is difficult to see oil prices staying above $100/bbl indefinitely. Ironically, the current oil shock is bearish for oil down the road because it will boost demand for EVs.
Gold Did Not Protect
Gold is down 13% since the start of the Iran conflict. Three forces have hurt gold. First, the dollar has strengthened while interest rate expectations have risen. From a macro perspective, a stronger dollar and higher rates are usually bad news for gold. Second, gold and, to an even greater extent, silver were overbought going into March. As we have seen in past episodes, including in October 2008, when gold fell 21% over two weeks, risk-off episodes can be painful for gold when a lot of retail money is holding the asset.
Third, some governments are cutting back on gold purchases to focus on other priorities. Poland’s central bank is reportedly considering selling gold to finance defense spending. Turkey has also been selling gold reserves in recent weeks to defend the lira. Both central banks were aggressive buyers of gold over the past few years. Ultimately, we think these forces will wane. Therefore, we remain positive on gold but don’t expect to see the same spectacular returns as in 2025.
Our Portfolio Positioning
We continue to closely follow events in the Middle East, as the closure or reopening of the Strait of Hormuz will be the key market driver in the short term. If the conflict de-escalates in the next month or so, overall damage to the global economy should be limited. However, if oil prices remain high for an extended period, it will increase the risk of a global slowdown or even a recession.
In our core portfolios, we have a slight defensive tilt, with an overweight in healthcare, Europe, and emerging markets. Given the structural economic factors, we remain comfortable with the current positioning. While U.S. assets have fallen less than non-U.S. assets since the start of the Iran War, we expect the safe-haven effect to wane later this year and for non-U.S. assets to resume their outperformance. In the near term, we do expect heightened market volatility as markets adjust to new information about the Iran War daily. We will, of course, follow markets closely, but for the moment, we prefer to be defensively invested rather than waiting for the outcome in cash.
DISCLOSURES
The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The U.S. consumer confidence index (CCI) is an economic indicator published by The Conference Board to measure consumer confidence, which is defined by The Conference Board as the degree of optimism on the state of the U.S. economy that consumers are expressing through their activities of savings and spending. Global consumer confidence is not measured.
The Institute for Supply Management (ISM) Manufacturing Index shows business conditions in the US manufacturing sector, taking into account expectations for future production, new orders, inventories, employment and deliveries. It is a significant indicator of the overall economic condition in US. The ISM Prices Paid represents business sentiment regarding future inflation. A high reading is seen as positive for the USD, while a low reading is seen as negative.
The S&P 500 Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance.
