Can we be a bit more optimistic?

Taking a break and coming back from vacation, here’s Nohshad’s new weekly report:

I can already see hints of the final outcome……after this war has been escalating for nearly five weeks. Even before the conflict broke out, I kept warning about the risks facing the energy market, the knock-on effects on global growth and inflation, and the market’s severe underestimation of these risks. As I wrote earlier, it appears that all sides in this conflict have fallen into the classic escalation trap. America’s military dominance is beyond question—it has destroyed more than 12,000 targets in a short period, substantially degrading Iran’s ability to strike. However, the asymmetric warfare and lateral escalation strategy used by Iran—something typically effective when facing a much stronger opponent—has proven effective, most notably by blocking the Strait of Hormuz, the key choke point for energy, fertilizer, and helium trade. Polymarket’s current odds show an 80% probability of a ground invasion by the end of this month, reflecting the market’s extreme pessimism about where this conflict is headed.

In my view, that probability is too high. From President Trump’s nationwide televised remarks on Wednesday, I conclude that the U.S. currently seems unlikely to try to reopen the strait by force. Doing so would require a much larger deployment of troops (including ground operations), carries a very high risk of casualties, and would very likely trigger a rapid regional escalation……possibly pulling in multiple countries and non-state actors and causing serious damage to energy infrastructure. In my view, the timeline for a military-led reopening (months of fighting) doesn’t match the style most presidents usually prefer—“quick and decisive”—and he also wants to avoid a prolonged war and the domestic political consequences that would follow. Instead, the U.S. president seems inclined to continue its current pattern of airstrikes, while keeping the door open for negotiations, so that after hostilities cease, the strait will “naturally reopen.”

On the Iranian side, although tough wartime rhetoric has always been present, their response has remained to a certain extent restrained and reciprocal. In my view, this indicates they want to pause a hot war while still maintaining control over strait traffic. Remember, for the market, the key factor is simply restoring passage through this critical energy chokepoint. I can imagine a scenario like this: the U.S. gives in over the next few weeks, leaving international society to negotiate the reopening of the strait. By then, Iran would have almost no incentive to continue blocking international traffic through the strait; its top priority would shift toward rebuilding and maintaining some semblance of a functioning nation-state. European and Asian countries could then readily declare they were not involved in the conflict, allowing them to step in and facilitate a broad international agreement……under which Iran may offer more favorable terms to some countries than to others. Both sides would be able to claim victory……the U.S. effectively destroys Iran’s military capabilities, while the Iranian regime survives. Ultimately, it becomes increasingly clear: after escalating the conflict to its current stage, neither side is willing to take the next step, and the costs would be far higher.

Source: Citadel Securities, Bloomberg

This does not mean economic fallout from the conflict can be avoided. Damage to global energy and trade flows has already become materially evident……for now, it appears that a significant jump in overall inflation is unavoidable……supply-chain disruptions will spill over into the global economy over the coming months. Higher prices may weigh on consumer confidence, while the shock from uncertainty will suppress hiring and investment decisions. It seems at least some central banks will respond by tightening policy……however, given the lack of post-pandemic reopening prosperity and strong fiscal support, this means the transmission of such shocks into core inflation should be far lower than in 2022. Inflation expectations remain the key channel that could worsen the situation, and they are a key risk that needs close monitoring. In my baseline forecast, I expect Europe, Australia, and Japan to raise rates one to two times, while the Bank of England and the Federal Reserve will hold steady. This leaves some room for a rebound in global front-end interest rates, even though the magnitude won’t be that large. For the broader fixed-income market, what matters more is that once front-end rates find their clearing level, the middle section of the yield curve can price in expectations for negative growth. The reversal in stock-bond correlation last week represents a fundamental shift in how the market is trading the conflict in the next phase. I began going long fixed-income assets last week, and the subsequent performance reflects a new dynamic that is taking shape: as worries about economic growth start to dominate, duration becomes less sensitive to oil-price gains, but it still remains asymmetrically sensitive to oil-price declines or cooling conditions—those that drive yields lower. I expect fixed-income products to continue to rebound, led by the middle segment of the yield curve.

The stock market should start to perform now……because if my analysis above is correct, the large tail risks tied to the worst escalation scenarios are fading. This includes the risk of further structural damage to energy infrastructure, the U.S. ground troops’ months-long participation in the conflict (along with the risk of getting stuck in a quagmire), and the long-term interruption of global trade. Although the rates market will keep focusing on near-term prospects, forward-looking equities should start to rebound, because they are gaining more confidence about the outlines of the conflict and its impacts. Institutional positioning remains relatively light—high gross exposure but low net exposure—and periods of extreme pessimism are usually accompanied by rebounds driven by “underpositioning” (underweighting). In these phases, the stock market will ignore near-term disruptions and instead focus on earnings further out (which may remain resilient over the medium term), as well as potential easing in financial conditions driven by falling yields. Stocks won’t only rebound after uncertainty is fully eliminated……when the boundaries of uncertainty become clearer, downside risks are clearly defined, and the market focus decisively shifts toward future earnings, the stock market will follow suit.

This article is sourced from Zhizao Mikko

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