Financial markets have never been good at anticipating and pricing regime changes, inflection points, and structural disruptions, a fact that has been particularly evident during the 14 months of Trump’s second presidency.
For much of that time, risk asset prices continued to rise despite elevated policy and macro uncertainty. Market volatility had been compressed, and complacency reigned.
But investors have underpriced the critical insight that domestic resiliency and national security have become the new priorities that redefine policy objectives. The ongoing rewriting of the rules of world order and the resulting fragmentation of global alliances in defense, trade and finance will raise the security risk premium across asset classes and geographies.
The Iran war has suddenly brought that message home with Brent crude oil’s jump above $100 a barrel raising the odds of inflation staying above the Federal Reserve’s 2% target this year, if not rising, limiting prospects for further rate cuts.
Despite ongoing investor concerns about its status, the dollar has rallied in line with its historical role as ultimate reserve currency. Meanwhile, 10-year global bond yields have moved higher as investors price in more inflation compensation. Equity prices have dropped, particularly in markets outside of the U.S. that had over-performed in recent months, such as South Korea and Europe. U.S. high-yield bond spreads are at their highs for the year at a time when retail investors are rushing for liquidity in private credit funds.
The cone of possible outcomes from here is very wide. Iran chose Mojtaba Khamenei as its new leader. The son of Ayatollah Ali Khamenei is strongly tied into the Islamic Revolutionary Guard, and there is no sign yet that he is pivoting toward negotiation.
Iran continues to attack neighboring states, including NATO member Turkey, according to news reports. The conflict is getting more drawn out, and, even if it subsides, there is a risk of an instable resolution where Iran retains its nuclear ambitions, and its material and know-how leak out to other hostile groups around the Gulf.
The attempt to bomb a nation into cooperation may not work. To quote former Secretary of Defense James Mattis: “The enemy gets a vote.’’
Crude oil tanker crossings through the Strait of Hormuz have dropped to near zero, and the conflict highlights the need for a long-term security plan for the energy chokepoint and energy infrastructure in the region.
Investors are grappling with the implications of an energy price shock, not only oil but importantly also gas. This comes after a series of supply shocks—the pandemic, the Russian invasion of Ukraine, higher tariffs, and tighter immigration policies—that scarred households’ and firms’ psychology. And it’s happening at a time when the U.S. has undercut non-carbon energy investment and when hundreds of billions are being invested in the buildout of energy-intensive AI infrastructure.
War is unsettling. It creates the highest forms of uncertainty and risk. In the case of Iran, the endgame is undefined and unknown, and the bombing of energy and water infrastructure could have high costs for the population, complicating a political transition.
Security risk is now suddenly getting priced into markets, but perhaps less than expected.
Could it be investors see some advantages of the West securing more energy and supply chain resilience, while limiting China and Russia’s influence over those assets?
Here is a possible benign outcome: In five years, Europe emerges better prepared to defend itself, with deeper capital markets thanks to more centralized fiscal policy and eurobond issuance. R&D spending from defense research has spillovers into the private sector in the form of technological innovation, contributing to much needed higher productivity.
The U.S. has more influence in its hemisphere and in strategic geographies, from the Middle East to the Arctic. Western democracies have more influence over global energy supplies, and, with Arab states, a plan to secure critical energy infrastructure and supply chokepoints like the Strait of Hormuz. The U.S. maintains dominance in AI and in research around key technologies such as photonic circuits.
One thing is certain if this scenario is to come about. The U.S. cannot always be a punitive force as it tries to get other nations—both allies and antagonists—to cooperate. It has to find a way to re-start diplomacy, using the tool of soft power and persuasion more often than the blunt force of tariffs or threat of conflict with key partners. Investors are finally coming to grip with the notion that security risk is here to stay. The endgame of the Iran conflict will determine where the security risk premium will settle, at least for a while. This is crucial because security cuts across a number of deeply interconnected structural forces—from geoeconomics to AI to digital finance to electrification and decarbonization.
A version of this blog first appeared on MarketWatch.
