Just two weeks ago, the prevailing Market narrative was remarkably constructive. Global equity breadth had strengthened to levels we had not seen in several years. Economic growth was firming, earnings momentum remained strong, and inflation appeared to be gradually cooling. The long-awaited “broadening” phase of the cycle, where leadership expands beyond a narrow group of mega-cap companies, was taking hold.
Today, that story has very much been placed on hold. The escalation of conflict in the Middle East and the resulting surge in Oil prices have introduced a new and more complicated variable into the macro-outlook. Global Markets have been weak since the weekend of the escalation. Markets have not collapsed, but they are clearly reassessing the durability of the broadening outlook in the face of a potentially prolonged energy shock.
The key question investors are now grappling with is not simply the existence of geopolitical tension. Markets have historically shown a remarkable ability to look through geopolitical events when their economic consequences appear limited. Instead, the central issue is duration. How long might higher energy prices persist, and what knock-on effects could they have on inflation, interest rates, and economic activity?
Thus far, US Equity Markets have handled the spike in Oil reasonably well. Major indices remain only modestly lower than their levels before the escalation began. That resilience reflects a widely held assumption among investors that the current Oil shock will ultimately prove short-lived.
One of our sources and a lead strategist at Piper summed it up well:
“Markets are increasingly behaving like a caller placed on hold during a customer service call. At first, the expectation is that the interruption will be brief — a momentary pause before the conversation resumes. Yet as the minutes tick by, patience begins to erode. Five minutes pass, then eight, then ten. Eventually, many callers simply hang up.”
The Market is approaching a similar moment of impatience. The conflict is now nearing two weeks in duration, and the path toward a rapid normalization of Oil flows remains unclear. As each day passes without a convincing decline in energy prices, the probability increases that investors will begin pricing in something more persistent and potentially more damaging.
Why Oil Is Driving Everything Right Now
Energy prices are currently dominating the behavior of global Markets to an unusual degree. The price of crude Oil has surged sharply, with WTI trading above $95 per barrel and Brent reclaiming the $100 level. What makes this development particularly notable is the degree to which Oil price swings have become tightly linked to movements in other major asset classes. Intraday correlations between WTI crude and S&P 500 futures have approached roughly -74%, meaning equity prices are moving almost directly opposite changes in Oil prices. Oil prices up = equity prices down.
At the same time, Oil has also shown a strong positive correlation with Treasury yields. Oil up = Rates up, adding more pressure. In other words, Oil is currently driving both equities and interest rates on the short run.
That dynamic reflects a simple but powerful macro narrative. Higher Oil prices raise the risk of renewed inflation pressure. Rising inflation expectations tend to push interest rates higher. And higher rates, particularly when combined with rising input costs for businesses, create headwinds for equity valuations.
According to AAA, retail gasoline prices have climbed to $3.63 per gallon, roughly 55 cents higher than a year ago. And roughly 63-70 cents higher than February of this year. In 2024, total U.S. gasoline consumption ran 137.8 Billion gallons. At 55 cents extra per gallon, that equates to roughly a $76 Billion annual drain on consumer purchasing power. If sustained, this represents approximately a 0.35 percentage point shock to disposable income.
Put another way, the average American went from $44 to $54.50+ for a full tank in the past 2 weeks, assuming national avg price for regular and a 15-gallon tank. For that 23% increase, Americans either pull from other parts of their budgets (something has to give), or draw down savings, or use debt and credit. The economic ramifications are clear if prices stick for longer or go up more.
The Federal Reserve’s Conundrum
Inflation or CPI has come down from roughly 3% last Fall to a recent reading around 2.4–2.5%. With current energy prices, that number could easily move back toward 2.8–2.9% in the coming months. If higher Oil prices persist for months rather than weeks, the implications become more serious. Sustained energy price increases would raise the risk of inflation reaccelerating at precisely the moment when central banks had hoped price pressures were finally stabilizing.
Markets have already adjusted their expectations. Interest-rate futures are now pricing less than one rate cut in 2026, compared with roughly two to two-and-a-half cuts expected earlier this year. An inopportune moment for the Federal Reserve to be forced to pause its rate-cutting campaign. Labor Markets have been softening, something policymakers were hoping to address with lower rates to help stimulate economic activity. But if interest rates remain higher for longer, the Fed’s ability to ease policy becomes significantly constrained.
30-year Fixed Mortgages have been at an average of 6.11%. With the 30-year Treasury yield pushing back to 5%, mortgages will need to reprice higher, putting the Housing Market back in a more difficult backdrop. Corporate profit margins, potentially two negatives from this shock, facing pressure from higher financing costs with higher rates, could also come under additional strain from rising energy expenses.
In short, a short-term geopolitical shock could evolve into a broader macro challenge the longer this lasts. That possibility explains why Markets are becoming increasingly sensitive to the trajectory of Oil prices and to every new headline regarding the conflict.
Why Oil Shocks Are Difficult to Model
Predicting the economic consequences of Oil price spikes has always been challenging. Oil shocks rarely behave the same way twice, and their effects depend heavily on the underlying cause. When Oil prices rise because of strong global demand, the broader economic context is often supportive. Higher prices reflect healthy growth and increase industrial activity. In such environments, Markets often absorb rising energy costs without major disruption.
Supply-driven Oil shocks, however, can be more destabilizing the longer they last. When prices surge because of geopolitical disruptions or supply constraints, the resulting increase in energy costs can act as a tax on economic activity.
Even so, the relationship between Oil prices and economic growth today is different than it was in previous decades. The global Economy has become significantly less energy-intensive over time. In the United States, energy expenditures represent a much smaller share of household spending than they did in the 1970s or even the early 2000s. Moreover, the United States has transitioned from being a major net importer of petroleum to running a petroleum trade surplus. These structural changes mean that simple historical comparisons can be somewhat misleading. Regressions examining the relationship between Oil prices and economic performance over past decades will likely get the direction correct. Higher Oil prices tend to weigh on growth, but they may significantly overstate the magnitude.
Yet while the Economy may be structurally less sensitive to energy costs, Markets may actually be more psychologically sensitive today than they were in the past. The inflation shock of 2022 left investors with significant scar tissue. For much of that year, persistent inflation forced central banks into aggressive tightening cycles and created substantial volatility across Financial Markets. The experience reinforced the idea that inflation shocks can have profound consequences for both economic policy and asset prices.
As a result, investors today may be quicker to react to signs that inflation pressures could return.
The Strategic Importance of the Strait of Hormuz
One reason the Market is treating this particular Oil shock seriously is the strategic importance of the Strait of Hormuz. Roughly 20% of global Oil supply flows through the Strait, making it one of the most critical chokepoints in the global energy system. But its importance extends beyond raw supply volumes. A significant portion of global refining capacity depends on crude that travels through this corridor. Estimates suggest that as much as 30–40% of complex refining capacity worldwide relies on Oil sourced from the region. Refining infrastructure is not easily adaptable. Many refineries, particularly in Asia, are specifically designed to process heavier Middle Eastern crude grades. Substituting alternative crude types often requires costly adjustments or results in lower efficiency.
As a result, even temporary disruptions to Oil flows through the Strait can produce ripple effects across global Energy Markets. Supply chains must be reconfigured, shipping routes adjusted, and refineries forced to process unfamiliar feedstocks. Those disruptions can persist long after the original shock subsides.
Global Markets Are Reacting Unevenly
While US equities have shown better resilience, the impact of the energy shock has been far more pronounced in other parts of the world. Major U.S. equity indices have declined roughly 3–5% since the escalation of tensions. By contrast, European equities have fallen approximately 9%, while emerging Markets have dropped close to 9%. Global equities excluding the United States are down roughly 7.5%.
This divergence reflects differences in economic structure and energy sensitivity. Europe entered the year with relatively modest growth expectations, with consensus forecasts pointing to GDP expansion of roughly 0.8%. In such an environment, a sustained increase in energy costs could easily tip parts of the region into recession, hence the larger Equity Market declines following recent events.
Emerging Markets also face greater vulnerability to energy price shocks, particularly those economies that rely heavily on imported Oil. Add in a stronger U.S. Dollar which we’ve seen since the conflict and the risk of a global growth slowdown, and it becomes clearer why Emerging Markets are being hit harder.
The United States, by contrast, benefits from domestic energy production and a more diversified economic structure. That relative insulation has helped U.S. equities outperform their global counterparts during the current episode. That advantage may not last indefinitely if we begin to see broader demand destruction and a longer-lasting growth hit.
Signs of Market Fatigue Were Already Emerging
It is also worth noting that Financial Markets were beginning to show signs of fatigue even before the geopolitical escalation occurred.
Market breadth had been deteriorating for several weeks, with fewer stocks participating in rallies and an increasing number entering downtrends.
Credit Markets had also begun to weaken. High-yield spreads have widened meaningfully, with the High Yield Bond index moving from roughly 290 basis points earlier this year to around 370. Similarly, spreads between BB-rated and BBB-rated corporate bonds have expanded from below 90 basis points to more than 120. These developments suggested that investors were already becoming somewhat more cautious. The geopolitical shock did not create those underlying vulnerabilities, but it has clearly accelerated them.
If Oil prices remain elevated, the Economy could face the more challenging combination of slower growth and rising inflation pressures. Such a dynamic, described as stagflation, would represent a far less supportive environment for equities. At the same time, higher energy costs could constrain central banks’ ability to ease monetary policy. Markets have already begun adjusting their expectations for interest rate cuts, with futures pricing now suggesting fewer policy easing moves than previously anticipated.
Adjusting Positioning
Given the increased uncertainty, we were quick to act this week and have taken steps to reduce portfolio risk.
Geopolitical risk was on our watch list entering the year, so this shift has not entirely caught us off guard. We took advantage of favorable prices earlier in the week to reposition some exposure and play a bit more defense. Our sense is that the Market may need some time to muddle through the current uncertainty.
Earlier this week, we used a Market rally to lighten exposure to cyclical sectors and add a hedging position in select active strategies. The goal of these adjustments is not to assume the worst-case scenario, but rather to acknowledge that the risk environment has become less favorable for broad risk-taking.
We reduced net equity exposure, reflecting a more balanced stance while we assess how the situation evolves.
Active investment management requires adapting to changing conditions. When the underlying facts change, positioning must be adjusted, and we pride ourselves on doing just that.
What Comes Next
In the near term, the direction of Oil prices will likely remain the most important variable for Markets.
If the conflict de-escalates and a clear path emerges toward lower energy prices, equities could rebound sharply. History offers several examples of Markets recovering quickly once geopolitical tensions begin to ease.
On the other hand, if Oil prices remain elevated for an extended period, the economic consequences may gradually begin to appear in incoming data.
In the weeks ahead, we will be paying close attention to several indicators that tend to respond early to shifts in the macro environment.
For now, the expansion story that dominated Markets earlier this year has not disappeared.
But it is clearly on hold.
Have a nice weekend. We’ll be back, dark and early on Monday.
Mike Harris
