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- [00:00]
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Welcome to Thoughts on the Market. I'm Michael Zesus, Morgan Stanley's deputy global head of research.
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And I'm Ariana Salvatore, head of Public Policy Research.
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Today we're discussing the escalating U. S. Iran conflict, the market reaction, and what investors should be watching for Next. It's Wednesday, March 4th at 7:30am in
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San Francisco and 10:30am in New York.
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So Ariana, I in San Francisco at Morgan Stanley's TMT conference. But obviously events in Middle east have captured everyone's attention. There's uncertainty around the conflict and really important questions about how it affects all of us. And of course, markets have to discount all sorts of future uncertainty about very specific impacts to financial asset prices, to commodity prices and really look at it through that narrow lens. And so Arianna, the administration has suggested that this conflict and this campaign could last a few weeks. But also it said it could continue as long as it takes. So what are the clearest signals investors should watch for to gauge duration?
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For now, we're focused on three main indicators. First, I would say, and most important, is clarity around the objectives. The president and others in the administration have referenced things like eliminating Iran's missile arsenal, its navy, and limiting proxy activity. Those goals are broader than the earlier focus on just the nuclear programs. Each objective, of course, implies a different timeline. A narrower objective likely means a shorter engagement. Broader ambitions, conversely, would extend it. So that's the first thing. Second, obviously extremely important is traffic through the Strait of Hormuz. We'd view this full closure as unlikely given the economic consequences for Iran itself. But tanker flows have at least temporarily fallen close to zero, and that's significant because production across the region has not been impaired. This is not about oil fields going offline. It's about whether or not oil can actually move. If shipping lanes normalize within weeks, markets can recalibrate. However, if flows remain materially curtailed beyond five weeks, the risks rise meaningfully. Third, the frequency of strikes and proxy activity sustained or escalating engagement would suggest a longer conflict. Signs of diplomacy, on the other hand, might indicate de escalation.
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Right. So let's build on that and talk about oil. And our colleague Martin Ratz has really laid this out with a lot of different scenarios. But what we're seeing right now is that when it comes to oil, this is really a shock to the transport of of it, not necessarily a shock to its production. So oil supply exists. The question is really can it be delivered or not? So if tanker flows normalize and the geopolitical risk premium fades What Martin is saying is that global oil prices could move back towards 60 to $65 a barrel. If the logistical disruption lasts four to five weeks, then prices maybe trade in the $75 to $80 range. And if disruption extends beyond five weeks and flows are materially constrained, then you could see a situation where oil prices have to rise towards 120 or $130 a barrel. And at that level, demand destruction is what becomes the balancing mechanism in setting price for oil. So one signal to watch is longer dated oil prices. Early month contracts can spike during geopolitical stress, but a sustained move materially above $80 to $85 barre would likely require longer dated prices to move higher as well. And that might signal that markets believe the disruption is persistent and not temporary. Arianna, what about natural gas here? How does that situation fit into the energy story?
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As of this recording, Qatar has halted liquefied natural gas production, putting roughly 20% of global supply at risk. Prices have, as you might expect, risen sharply, which likely reflects expectations of a relatively short disruption. If exports were to resume quickly, prices could retrace. But of course, if the outage lasts longer, prices could move meaningfully higher. Again, duration of the conflict is really
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critical here, so let's bring this back to the U.S. arianna, how does this conflict feed into the domestic political and economic backdrop?
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When we're thinking about the midterm elections later this year, the way we see it, the clearest transmission channel is gasoline prices. Polling shows a majority of Americans oppose military action related to Iran, but voters typically prioritize domestic issues. Things like inflation, cost of living, affordability over foreign policy. However, there's a very clear caveat here. If oil prices stay elevated, gasoline prices rise, and that's where this becomes politically more salient.
- [04:53]
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Right. And so our economists and our chief US Economist, Michael Gapen has been all over this, and the way he assesses it is if oil prices remain about 10, 10% higher than where they were before the conflict for several months, headline inflation would likely rise by 0.3% before dissipating. Historically, oil price shocks primarily affect headline inflation rather than underlying inflation. That's an important distinction that they point out. So maybe that could delay Federal Reserve rate cuts, even if policymakers ultimately look through the move. But if oil prices rise enough to weaken economic activity, particularly in the labor market or consumer spending, then our economists say the Fed could pivot toward easing despite elevated inflation.
- [05:39]
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So given that backdrop, what's the simple takeaway for investors in stocks or bonds?
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Right. So I think we have to think about this in terms of duration of conflict and economic impact. So if tanker flows normalize within a few weeks and oil prices move back towards that 60 to $65 range, then our economists are saying economic damage would be limited. And historically, geopolitical events alone have not led to sustained volatility for US Equities. So in that environment, our Cross Asset team points out that stocks would likely remain supported. If instead, oil prices remain elevated long enough to push inflation higher and weigh on growth, the picture would change a sharp and persistent rise in oil prices that can pose a risk to the duration of the business cycle and and in that scenario, we'd expect stocks to struggle. Importantly, bonds may not provide the same diversification benefit if inflation remains sticky. As a consequence of all this, we could see stock and bond prices move in the same direction. That could challenge traditional balanced portfolios.
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And what are we seeing specifically in US treasury markets?
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So, as Matt Hornback and our Global Macro Strategy team have pointed out here, you've got two competing forces. In the US treasury market, there's been some demand for safety, but investors are also focused on the risk that higher oil prices would lift inflation. So far, inflation concerns have taken precedence over growth concerns. How long that balance holds, that might depend on incoming data, especially labor market data. If you get weaker labor market data suggesting that growth could weaken, then you could see Treasuries rally more meaningfully and yields come down. If you don't see that and inflation concerns dominate, then maybe you're not going to see yields come down as much and bonds rally as much.
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So, stepping back, it seems like the key variables remain tanker traffic, longer dated oil prices, and duration of the conflict itself.
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I think that's right. Arianna, thanks for speaking with me.
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Always a pleasure, Mike.
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And thanks to our listeners for joining us. We'll continue tracking developments and what they mean for markets. If you enjoy thoughts on the market, please take a moment to rate and review us Wherever you listen and share the podcast with a friend or colleague.
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