Markets unsure of how to price in Middle East risks

On the one hand, markets cannot ignore the tail risk. An escalation, particularly involving strikes on energy infrastructure, would have far-reaching consequences, from a surge in oil and gas prices to potential disruptions in food and supply chains. That scenario would amplify inflation risks and tighten financial conditions globally, making it deeply negative for growth and risk assets. Importantly, it is also a scenario that would suit very few participants. The United States, despite its aggressive rhetoric, is unlikely to want to trigger a chain reaction that could destabilise the Gulf region and inflict economic pain not just on its allies, but on the global economy more broadly.

At the same time, there are increasing signs that Washington is looking for an off-ramp, a way to de-escalate without appearing to concede. The difficulty lies in the optics. Any retreat risks being framed as a loss, particularly in a politically sensitive environment, while following through on threats risks unleashing consequences that are difficult to contain. Iran, for its part, has little incentive to make that exit easy, using the Strait of Hormuz as leverage to maintain pressure and extract concessions, also sending a clear message deterring anyone from trying attacks in the future.

This leaves markets in a state of uneasy balance. Investors are tentatively pricing in the possibility of escalation, keeping a risk premium embedded in energy and safe-haven assets, while simultaneously leaning toward the expectation that a full-scale escalation will be avoided. The result is heightened volatility without a clear directional trend. Until there is greater clarity on whether the conflict intensifies or moves toward resolution, markets are likely to remain stuck in this holding pattern, reacting sharply to headlines but struggling to sustain momentum in either direction.