The Fog of War

Geopolitical risk has steadily risen over the last few years and recently culminated in the outbreak of war in Iran. U.S. and Israeli forces launched coordinated military strikes under Operation Epic Fury, citing the strategic objective of dismantling Iran’s nuclear and ballistic missile capabilities. However, the lack of a clearly defined measure of success or coherently articulated exit strategy has heightened uncertainty. Retaliation from Iran’s new leadership has compounded this ambiguity, leaving markets firmly entrenched in the fog of war.

The epicenter of the conflict is the Strait of Hormuz- a vital corridor between Iran and Oman which transports 20 million barrels of oil a day or roughly 20% of global consumption. With the Strait effectively closed due to Iranian control, Brent crude surged to nearly $120 per barrel before receding toward $108 as the war continues its third week. The duration of hostilities and the effective control of the Strait of Hormuz will determine the magnitude and persistence of the supply shock to global growth and inflation.

While the stakes are high and rising, creating pressure for resolution, incentives could prove the bigger lynchpin. For the U.S., the financial cost of a prolonged engagement, depletion of weapon stockpiles, and political fallout during a midterm election cycle, all point toward regional stabilization and subsequent exit. Israel, by contrast, views Iranian nuclear capability as an existential threat and stands to benefit from its degradation and any weakening in Iran-backed militant groups such as Hezbollah. As a result, Israel may exhibit greater tolerance for an extended conflict.

Given the asymmetry in resources, Iran knows a military centric path risks defeat. Iran’s incentive swiftly shifted toward broadening the conflict economically, most notably by weaponizing the Strait of Hormuz, to inflict global consequences. Iran also acted aggressively to widen the geographic reach by attacking energy infrastructure and civilian-linked assets in neighboring countries. These actions reflect Iran’s objective to ensure regime survival through economic leverage alongside military actions.

Other Gulf Nations now face not only missile and drone strikes but severe economic strain. The major oil producers, who are net exporters, are facing large production cuts and diminished revenue given the disruption of transport. As societal safety and economic damage mounts for the Persian Gulf, these nations will exert pressure for de-escalation.

Europe remains vulnerable to renewed energy price instability akin to the 2022 Russian gas supply shock. However, European leaders have thus far rejected direct participation in securing the Strait of Hormuz, despite Trump’s urgence. As the world’s largest oil importer, China also relies on cheap oil from Iran. As it did with Russian oil following the invasion of Ukraine, China could deepen economic ties with Iran, potentially acting as an intermediary to bolster the weakened regime. Europe and China appear to have different motivations toward security in the region.

Incentives do vary, but most appear skewed toward a diplomatic resolution measured in weeks, not months. Oil futures markets seem to support this view; the Brent curve remains in backwardation, with prices implied near $77 per barrel by year end. Equity markets echo this calm as the S&P 500 index remains only a few percentage points below its all-time high. Under this scenario, supportive economic policy, strong earnings, and AI-induced productivity gains should support stocks through the short-term dislocation in energy supply.

Divergent incentives raise the risk of an ‘escalation trap’ wherein initial tactical success gives way to a prolonged conflict driven by each side’s need to avoid defeat. The U.S. cannot claim victory if Iran retains control of the Strait of Hormuz, yet reopening the Strait would entail an elongated and messy war. With a long and storied history of enduring sacrifice, Iran is fighting for the survival of the Islamic Republic itself. In this scenario, a prolonged oil shock increases the risk of stagflation – defined by slower growth and higher inflation – which is historically proven hostile to financial markets. Although U.S. energy independence provides some insulation, secondary effects, including higher fertilizer and food prices, risk entrenching structural inflation.

We do not know how events will unfold. While history suggests that market reactions to regional conflicts are typically transitory, current valuations imply a degree of complacency. Unforeseen events could trigger a risk spiral, particularly given the clash between governing ideals of a theological adversary and a democratic superpower. However, this remains a tail risk rather than the consensus view.

Outside of such an extreme scenario, we believe adhering to our investment discipline will provide a measure of protection and the opportunity for long-term growth of capital.
Asset allocation remains the cornerstone of navigating volatility, and we favor staying closer to target allocations amid a fluid risk-reward landscape. Our portfolios emphasize diversification and high-quality companies with resilient business models capable of enduring economic and market cycles. Despite short-term price swings, quality companies serve as long-term stores of value as markets ultimately reward operational excellence. Guided by this compass in the fog of war, we remain steady at the helm.