Our scenarios around the Israel-Iran conflict

Financial markets have responded in a measured way to the hostilities between Israel and Iran. The main focus has been the price of crude oil, as equity and fixed income investors price in a contained conflict. We examine the outlook for financial assets with two scenarios; our expectation for a limited conflict, and a second, less-likely escalation into a protracted broader conflict.

Brent crude oil prices have risen to three-month highs and gold, a traditional haven asset, is close to its record of April. However, US Treasury bond yields gained around 10 basis points and the VIX, which offers a reading of US equity volatility, has remained moderate by historical standards. Even the reaction of high yield US corporate bonds, a sector containing a large share of energy businesses, has been limited.

This is because over the last few years conflicts in the region have remained relatively contained. While there is a risk that the confrontation becomes prolonged and intensifies, many parties have an interest in reducing tensions. Iran would prefer to see the sanctions imposed by western nations rolled back, creating an incentive to negotiate, as recent news flow suggests. Europe, the US and China do not want to see persistently higher oil global prices, which would undermine efforts to cut energy prices to their economies. Both the European Union and US are therefore involved in diplomatic efforts, and it remains possible that mediation efforts may be supported by China and Russia. This balance of diplomatic interests will be on display at the meeting of Group of Seven leaders in Canada this week.

Our base case: de-escalation and a diplomatic path

A controlled confrontation leading to a deal between the US and Iran remains, in our view, the most likely evolution for the conflict. This is likely to keep diplomatic solutions open but leave core issues unresolved, including a more far-reaching agreement on Iran’s nuclear programme.

OPEC+ has the capacity to more than offset any shortfall

In this environment, the global macroeconomic implications would be relatively minor and central banks would likely focus on any impact on broader inflation. Oil prices would remain temporarily volatile, but ultimately settle lower towards our 12-month price target for Brent crude of USD 58 per barrel, from today’s USD 71. Indeed a brief price spike is unlikely to have a meaningful impact on the world economy. We expect the OPEC+ cartel of oil producers to respond to any threat to supplies by increasing output. The group has the capacity to more than offset any shortfall created by Iranian crude supply disruptions.

Central banks tend not to overreact to oil price spikes, due to their transitory nature, and instead they focus on “core” inflation, which reflects demand dynamics rather than supply-side shocks. The Federal Reserve and Swiss National Bank both meet this week: we expect the Fed to remain on hold, and make a total of three cuts over the rest of 2025, and the SNB to make a final 25 basis point cut, with a risk that interest rates have to return to negative territory in the second half of the year.

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Navigating a multi-polar world through structural themes in equities

June 5, 2025

Market reactions to recent confrontations in the region have been short-lived, with equity indices and oil prices typically reverting to their prevailing trends within approximately two weeks (see charts 1 and 2).

We keep our portfolio positioning unchanged for now. We expect equity markets to retain their upside potential, driven by earnings growth. We maintain our overweight allocation to global equities, and preference for communication services and materials, with an underweight exposure to the energy and staples sectors.

Read also: Corporate confidence points to further equity upside

We expect equity markets to retain their upside potential…

In fixed income, we see US Treasury yields consolidating before resuming their trend lower, while corporate bond spreads tighten. Our overweight exposure to government and investment grade bonds, together with a neutral position in high yield corporates, should help to buffer portfolios from a potential growth shock and equity volatility.

Under this scenario, commodity markets should stabilise. We expect oil prices to decline as supply disruption fears fade. Despite recent volatility in the oil market, investors’ longer-term inflation expectations have not significantly changed. In an environment of improved risk appetite, we see gold prices consolidating and eventually underperforming equity markets. We also expect currency market sentiment around the US dollar to stabilise from extremely negative levels.

Risk scenario: escalation and broadening conflict

We cannot of course rule out a broader regional escalation, and deeper US involvement. Any attack on US assets, the Gulf region’s oil infrastructure, or Iranian efforts to hinder maritime traffic through the Strait of Hormuz in a further escalatory spiral could trigger an international response, led by the US. That would sharply increase pressure on Iran’s political leadership.

For now, such an escalation looks like a low-probability, as several factors argue against disrupting energy routes and/or supplies. A blockade of the Strait of Hormuz would increase the likelihood of direct US involvement while cutting off Iran’s oil exports and its primary source of revenue. That would penalise China’s economy, which is a primary destination for Iranian oil passing through the Strait. Furthermore, such a move would damage Iran’s already fragile regional ties that the country may hope to exploit diplomatically. These risks would make a blockade a high-cost, high-risk option for the Iranian regime. This risk scenario could push oil prices to USD 80 to 90, before progressively declining over 12 months. If the Strait of Hormuz were blocked, a temporary oil spike above USD 100 is plausible.

Monetary policy focus will stay on core inflation, which better reflects underlying demand dynamics

Such a scenario would then inevitably impact headline US inflation, which we already expect to reflect higher average import tariffs this year. A sustained 20% to 30% increase in crude oil prices typically depresses global growth by between 0.5% and 1.0%, and raises global headline consumer price inflation by a similar margin.

So far, this conflict remains contained, with market nerves reflected - as expected - in commodity prices, particularly crude oil. For now however, we do not see signs of irreversible escalation. Nevertheless, if uncertainty and higher energy costs linger, there is potential for slower economic growth and higher inflation. The Fed typically looks through oil price shocks, which it sees as supply-side events. We think monetary policy focus will stay on core inflation, which better reflects underlying demand dynamics, and we remain alert to any need to adjust our portfolio positioning.