Escalate to de-escalate? Relief rally takes a breather, for now

Key takeaways

• Markets rebounded last week on hopes of de‑escalation, but uncertainty remains: Early optimism that the Iran conflict may wind down fueled a relief rally, though uncertainty around a clear off-ramp and ongoing risks to the Strait of Hormuz keep volatility and oil prices elevated.
• Duration of the oil shock is the key: In our view, a short disruption (three to four additional weeks) would likely see oil prices ease, global growth stay intact, and equities deliver modest gains, while a prolonged closure (three to four months) risks sharply higher oil prices, supply shortages, and rising recession probabilities, especially outside the U.S.
• U.S. fundamentals remain resilient; stay disciplined as investors: Recent data on retail sales and manufacturing point to steady trend growth, underscoring that the U.S. economy is showing signs of resilience. Avoid emotionally charged investment decisions, and remember not to play geopolitics with your portfolio.

Markets hope for de-escalation: What we saw last week

Markets began the week hopeful that the Iran war may be winding down. The administration's rhetoric pointed to two to three weeks before the U.S. would exit Iran, indicating it would even consider leaving without a deal in place. Markets welcomed the news of some end to the crisis and hopes of de-escalation in the region, and stocks rallied sharply at the start of the week.

However, the president's address on April 1 seemed to focus more on escalation of the military operations in Iran, rather than peace negotiations or exiting. There was little note of how the Strait of Hormuz may reopen to support global oil flows, but a notion that this may happen naturally once the war concludes. Perhaps the silver lining was that the two- to three-week period was still referenced, albeit more as the peak of military escalation, rather than a wind-down of operations.

In addition, reports emerged that Iran is drafting a protocol with Oman to monitor vessels crossing the Strait of Hormuz, and that Iran may be looking to set tolls to cross the strait. These reports helped provide a bit of stability in markets that are clearly looking for signals that global oil flows may resume over time.

By the end of last week, markets rebounded from the lows, and the S&P 500 index was positive for the week, after five straight weeks of negative returns. Overall, uncertainty and oil prices remain elevated heading into the long weekend, but glimmers of hope appear to be emerging that de-escalation and better oil flows may be on the horizon.

Duration of the oil shock matters

From an economic perspective, we think the key variable remains how long the oil shock lasts. Below we explore two scenarios that outline how long it takes for the Strait of Hormuz to gradually reopen, and the potential implications for markets and global economy under each.

Tail-Risk Scenario (three to four months of closure): If the strait is essentially closed for the next three to four months, oil prices will likely move sharply higher and physical oil and petroleum shortages could emerge across the globe. We think there would be meaningful downward pressure on the global economy, as oil prices rise further and second-order impacts like rising fertilizer and petro-chemical prices start impacting food and manufacturing costs. In this scenario, we see the probability of recession, especially in countries in Asia and Europe, rising substantially. The U.S. economy likely slows to below-trend levels as well, given higher prices at the pump and in grocery stores, putting immediate pressure on lower-income households and offsetting many of the tax refund gains.

Base-Case Scenario (three to four additional weeks of closure): In this case, the duration of the oil shock is closer to three to four additional weeks, before the Strait of Hormuz slowly starts reopening, and the spillover impacts are likely more contained. We believe oil prices should gradually move lower, toward $70-$80 range for WTI, and the global economy avoids recession. In the U.S., while economic growth may be negatively impacted, we would expect GDP growth to be in line with trend levels of 1.5% to 2.0%. Headline inflation would likely still rise toward 3.5% in the near term, but could moderate over time. In this scenario, we would expect equity markets to continue to deliver modestly positive returns, driven still by U.S. stock markets.

In our view, the second, more benign scenario remains the highest probability outcome for now, given it would benefit all parties involved. Notably, markets are also pricing in a relatively short-lived oil price shock. The WTI futures curve continues to point to a sharp deceleration in oil prices, returning to around $71 by year-end. This indicates that investors are also viewing this crisis and oil shock as one that will start to revert to the mean in the weeks ahead.

Fundamentals also remain a focus

The U.S. economy also continues to show signs of resilience in recent economic datapoints. Last week, both U.S. retail sales and ISM manufacturing data came out above expectations. The retail-sales figure for February showed retail sales excluding autos advancing by 0.5% monthly, above forecasts of 0.3% and last month's flat reading. This points to a U.S. consumer that continues to spend at a healthy rate, heading into the Iran crisis. Meanwhile, ISM manufacturing for March came in at 52.7, above forecasts of 52.3, and still indicating expansion in the U.S. manufacturing economy.

In addition, we will get a full jobs report on April 3, but the ADP private-payrolls report for March released earlier in the week indicated an addition of 62,000 jobs, above forecasts of 40,000. And finally, the Atlanta Fed GDPNow forecast is pointing to a 1.6% economic growth rate in the first quarter, a rebound from last quarter's weaker 0.7% growth.

Overall, the U.S. economy seems to be on pace for steady growth in the first quarter, with no meaningful signs of cracks, in our view, despite the geopolitical uncertainty that emerged in March. We will continue to monitor both inflation and economic growth metrics in the weeks and months ahead, but the early signals of resilience are a good reminder that the U.S. economy entered the current crisis from a position of relative strength.

Don't play geopolitics with portfolios

Overall, despite the headline noise, U.S. equity markets are down just about 4% this year, after three years of double-digit gains. We believe that for long-term investors, now is not the time to make emotionally charged investment decisions, but to instead consider a simple pulse check on your portfolio:

1) Do you remain aligned with your strategic allocations in equities and bonds? There may be an opportunity to rebalance if some investments have moved in an outsized way.

2) Do you have excess cash or cash-like instruments that could be used opportunistically? If so, this might be a good time to look at quality investments that have repriced lower and gradually add them to portfolios.

You can take these steps on your own or talk to your financial advisor who can help ensure that you remain on track to meet your financial goals. Remember, your diversified investment plan is designed to help you withstand bouts of market volatility over the long term, regardless of the geopolitical uncertainty we may be facing today.

Mona Mahajan
Senior Investment Strategist

Source for all data in commentary: Bloomberg

The Week Ahead 

Important economic data for the week ahead includes the ISM Services PMI and CPI inflation for March.

Review last week's weekly market update.