Markets Becoming Desensitized To Iran Risk – Focus Shifts To Growth Impacts
The war in Iran didn’t get worse over the weekend, which has sparked a relief rally in risk assets, but ‘not getting worse’ falls well short of shifting a fundamental reality that remains fragile. As of Friday’s close, the world stock market had lost -5.5% of its value since the start of the war (-3.6% for the S&P 500) in the worst start to any month since 2022. Only 35% of the members of the global index are now trading above their 50-day trendlines, so breadth is clearly deteriorating. On Friday, both the S&P 500 and Dow undercut their March 9th lows (with the Nasdaq barely holding, down 4.9% ytd). The S&P 500 index has fallen in each of the past three weeks (negative for five of the last six) and is down -3.1% for the year.
Complicating the investment setup is the inability of Treasuries or bonds to act as an offset to declining risk assets. The 10-year T-note yield has moved up to the high end of its recent range, and the U.S. dollar is pushing up to its high for the year as the DXY index breaks above the $100 level. In last Thursday’s market action, the most disturbing move of all was the +9-basis-point surge in the yield on the 2-year note to 3.74%. In a day where it was risk off everywhere, the least risky part of the Treasury curve posted the worst performance by a country mile. Keep in mind, we’re talking about a security with minimal duration and inflation risk. The 2-year note is the purest security for gauging the markets' expectations of Fed policy. At 3.74%, the yield is now trading at a +10-basis-point premium to the policy rate. It has soared by 36 basis points from the February 27th closing low of 3.38% and is back to where it was in August 2025, when the funds rate was 75 basis points higher than it is today. This is the bond market pricing out Fed cuts, which reflects what has happened in the swaps market, where there is now just a 50-50 chance that the Fed cuts rates this year, with nine months still to go, and the first full move is not being discounted until September 2027.
The biggest risk for markets remains oil prices, and the pace of transit through the Strait of Hormuz returning to normal levels. While U.S. Marines off the coast of Iran will surely help redress the drone risks, Polymarket betting odds show just a 38% chance of the Strait of Hormuz returning to normal by the end of April – down from nearly 80% just a week ago. Reopening the Strait is clearly easier said than done, but make no mistake: either the U.S. or the world will get the Strait reopened – there is too much at stake not to. The economic incentive for the world vastly outweighs Iranian interests and/or ability to keep it restricted – normally 20mbpd of oil transits daily through the Strait (including 2mbpd of Iranian oil). Currently, it's estimated that just 2-4mbpd is getting through, plus another 5mbpd from Saudi/UAE ramping up flow through the East/West pipeline, and roughly 2mbpd from the IEA’s strategic oil reserve, which can’t make up the shortfall, but we are seeing the world adapt, which is relieving some of the stress.
However, the thesis I’ve struggled to overcome at this point is the asymmetric threat: with a couple of low-cost drones and fast boats, Iran can plausibly enforce a partial closure of Hormuz for as long as it wants. It only takes one viable strike on a VLCC tanker or something else to keep transit flow below levels the world needs. It feels like a remarkably cheap way to keep perhaps 2–5m barrels off the market, potentially for a long time. One thing that Tehran has taught us this month is how it can remain a menace to the world even as its economy and military infrastructure get obliterated. It likely is true that over 90% of its missile and drone capacity has been taken out, but the remaining 10% is hardly trivial, and the launchers are obviously difficult to target since they move above and below ground in a heartbeat. If you live in Tel Aviv, you know first-hand that Iran still has plenty of missiles, and the Gulf region knows that there are enough drones (and naval mines) to totally disrupt the flow of oil and natural gas. The question becomes one of time and patience, and with Donald Trump facing opposition at home and among his MAGA base, the GOP losing all of these special elections in a midterm voting year, and the surge in gasoline prices working against the President’s “affordability” campaign, the question becomes one of staying power.
Back to markets and the repricing across asset classes that is currently underway. You have several factors forcing this repricing, with oil being a major culprit, but it’s also the U.S. dollar at the high of the year (the same goes for interest rates), and now credit spreads (both Investment grade and High Yield) are widening. All of this feeds into a meaningful tightening of financial conditions, with the GS Global FCI rising more than 50bps over the past two weeks – the strongest tightening impulse since August 2023 and one of the largest moves outside of a true crisis. This tightening in FCI, when factored into pricing models, results in higher risk premiums and lower valuations.
The last two weeks represented the most intense repricing we’ve seen during this six-month consolidation in the S&P 500:
Global equities fell -1.5% vs. -3.9% in the prior week.
Non-US stocks were down -1.6% vs -6.9%.
The S&P was down -1.6% vs -2.0%.
The Russell 2000 fell -1.8% vs -4.1%.
Emerging Markets declined the least (-0.9% vs -8.4%) thanks in large part to Chinese equities (MCHI: +1.9% last week), anchored by Tencent’s +5.5% move on its launch of agentic AI products.
What is also notable is that over the past two weeks, is that we’ve seen a reversal in what was market leadership in the first two months of the year:
Since the start of March, the S&P 500 is down -3.6 pct vs a decline of -8.4 pct for ‘Rest of World’ stocks. The YTD gap between the two has declined to 4.7 percentage points from 10.4 points at the end of February.
The Nasdaq Composite has outperformed the S&P 500 in each of the last 2 weeks (combined +1.1 points) after underperforming through February (combined -2.9 points).
The Russell 2000 has badly lagged the S&P 500 over the last 2 weeks (-5.9 points), entirely erasing the YTD lead it enjoyed through the end of February.
There has also been a change in market internals, typical of what you would see in advance of a phase transition, with cyclicals (Financials, Industrials, and Discretionary) underperforming defensive groups (Staples and Utilities). As of Friday's close, Transports have been clocked for a -10% decline from their highs; Consumer Cyclicals by -12%; and the Homebuilders are down -25% to a nine-month low. As always, the Financials are the proverbial canary in the coal mine and have collapsed by -14% from their highs, back to where they were last April during the Liberation Day fiasco. Consumer finance stocks have tumbled by 26%, and regional banks are nearly back in bear-market territory (-19%). Asset management stocks are already down 23% from their recent peaks, and there is no bottom in the overall market until the companies that manage money find a trough.
Look, I don’t want to pile on here, nor is it of any value to investors for me to sugarcoat the current backdrop, but this price action is more consistent with an oncoming bear market than a vibrant bull market. Moreover, should these trends continue in the weeks ahead, I suspect the market narrative will shift more resolutely to concerns of an economic recession. This isn’t me making a recession call, but rather just calling ‘a spade a spade’ by recognizing recession probabilities have increased over the past month. We have an oil price spike that, if not reversed in the next several months, will bite into already squeezed consumer wallets. Payrolls recently surprised to the downside with a negative 92k print (not a hallmark of a vibrant economy). Stocks have sold off roughly 5% from their highs, with many market segments down far more, and we are seeing early signs of stress in parts of the private credit ecosystem. None of these developments by themselves would derail the cycle, but what matters more is the stacking of these shocks that pushes the market into a more fragile regime.
On the flip side, we are starting to see a decent amount of degrossing and sentiment resets coming through the data. CTAs, while still expected to be net sellers into month-end (assuming nothing significantly changes), have cut their equity exposure by more than half from their January peak.
Bears (46.4%) are now handily outnumbering bulls (31.9%) in the latest AAII sentiment report, the NAAIM exposure index is down to 66.99 from 97.92 at the start of the year, and the CNN Fear and Greed Index has moved into extreme fear territory at 23. It's fair to say that sentiment and positioning now look much better calibrated to the risks than they did a few weeks ago. The challenge is that the macro backdrop itself has become less supportive as well.
The question now is whether the macro shock that triggered the reset stabilizes or continues to tighten financial conditions further. Clients reading this missive know that I sent out a note early last week informing them that we were making moves to trim some risk exposure out of portfolios. No, it wasn’t a ‘dash to cash’ note, but rather an acknowledgment that risks have increased enough to warrant an allocation pivot from a capital appreciation strategy to one more balanced with capital preservation. I don’t think we’re far enough down the path to put on the recession playbook, not to mention how poor a strategy that has been since the GFC, where the U.S. has been in recession for all of two months (March & April 2020) over the past 15+ years.
Over this 15+ year period, there have been many crises that could have derailed the domestic economy, but none ever did. The Greek Debt Crisis in 2011, the Fed’s policy mistake in 2018, the inflation spike and the most aggressive Fed hiking cycle in four decades in 2022/23, Russia’s invasion of Ukraine and oil price spike in the same year, and the April 2025 U.S. trade policy shock all fit the bill for expansion-ending events. And yet, not a single one caused a recession.
A big reason for that is the resilience in not only the U.S. economy but also corporate profits.
In the 64 quarters since 2010, the S&P 500 has posted year-over-year operating earnings growth in 52 reporting periods, or 81% of the time. The only exceptions were a typical mid-cycle earnings recession in 2015 – 2016 (6 quarters), the Pandemic earnings recession (4 quarters), and a temporary decline due to difficult comparisons (Q4 2022, Q1 2023). During this stretch, S&P 500 operating earnings have compounded annually at +8.0% per year since 2010 – a stronger pace than the +6.4% rate from 1990 – 2010. This is one of several factors (passive investing, decline in publicly traded companies, growth of Tech oligopolies…) that help to explain why the forward P/E multiple on the S&P 500 ranges between 18x-24x vs. the historical average of around 16x.
As far as I’m concerned – which is narrowly framed in terms of market and economic impacts – this Iran war is becoming less of a risk. All bets are off if a drone strike hits a tanker in the Strait of Hormuz, or the Houthis step up threats to the Red Sea and Bab al-Mandab Strait, but if not, then investors are right to start shifting their focus back to other fundamental drivers (liquidity, growth, inflation, and corporate profits). If oil stabilizes, the labor market shows modestly positive prints, and credit stress remains contained, the recent de-risking could ultimately create room for the market to find its footing.
However, given the increased risks (oil price equilibrium structurally higher, cracks in credit, higher interest rates across the globe, lack of central bank policy support absent a destabilizing event, and AI disruption), I continue to lean towards caution rather than optimism. An S&P 500 trading at 6,700 with a 21x forward P/E multiple doesn’t leave much of a margin of safety for downside scenarios. An S&P 500 trading at an 18x-19x forward P/E multiple, with earnings estimates staying relatively firm, gets you to around the 6,200 level, which is an area where I would be much more inclined to add risk to client portfolios. That would represent a little more than a 10% correction from the all-time highs of 7,000 and likely mark a solid cleansing of excess sentiment and positioning, setting the stage for a renewal of the bull market.
One final thought before signing off on this week’s missive. What this war is forcing to the surface is the fragility of global supply chains, regional vulnerabilities to specific natural resources, and reliance on energy of all forms. As a result, before the dust settles, I expect global leaders and investors will be shifting their attention to shoring up a reliable mix of green energy (solar), coal, and nuclear. As has been the case following every major geopolitical inflection point of the past fifty years involving a security-of-supply issue, one can expect a secular trend toward asset-light-to-asset-heavy sectors (the HALO trade). Tech and Communication Services today account for 45% of the S&P 500 market cap, while old-economy Industrials & Basic Resources command less than a 15% share.
It’s hard to deny that China has been a surprise winner over the past year; no visible impact from Trump’s tariffs (trade surplus is at a record $1.2 trillion), gained serious ground in the AI war, and emerged as one of the few winners in the Iran war. But it's China’s energy dominance that jumps off the page for me. It is in a league of its own in clean energy, where its investment hit $1 trillion last year, and the country has helped Asia become the undisputed global epicenter of nuclear energy growth. It has 38 reactor units of various types currently under construction and is on track to surpass the United States in installed nuclear capacity by 2030 (India is scaling up, as is Korea and Japan) – about three-quarters of all reactors under construction worldwide are in Asia, and the region is expected to generate roughly 30% of global nuclear power this year. The scale of the nuclear buildout is striking – around 145 operable reactors, roughly 45 under construction, and plans for another 65 to 70. So much ink has been spilled over how vulnerable China was to the Iran war, but all indications suggest they have experienced little to no impact on their energy trade. Not to mention how successful they’ve been in weaning themselves off reliance on fossil fuels for some time.
This is one of many reasons I remain a secular bull on Southeast Asia and emerging markets in general. They aren’t immune to global disruptions, but the fundamental setup continues to look constructive. I suspect investor flows to EM will resume on the other side of this Iran war, where Brazil looks particularly interesting: Flavio polling close to Lula, vast agricultural and oil resources, and being geographically far removed from Hormuz make it a structural winner the longer this disruption persists.
*** You get a break from me next week as I will be on the road visiting clients. I’ll be back in two weeks, and I’m confident that I’ll have everything figured out by then.
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