The Curse of Complacency

Key takeaways:

• Geopolitical events historically have had a short-term impact on the market; however, there are exceptions, and the common denominator in those exceptions was oil supply disruption.
• The financial market’s reaction, so far, implies the impact of the Middle East conflict will be short term.
• The conflict couldn’t come at a worse time for the market. Stock valuations are historically high and the conflict could further complicate how the Federal Reserve must navigate a weakening labor market versus inflationary pressures.

Wall Street has developed a strong Pavlovian response over the past several decades: When geopolitical conflict erupts, the playbook is to hold steady and wait for the headlines to fade.

Since World War II, the S&P 500 has declined an average of roughly 5% following major geopolitical shocks, typically bottoming within three weeks and recovering within two months. That track record has conditioned an entire generation of investors to treat armed conflict as noise rather than as a signal. The question worth asking with the Middle East conflict is whether a “this too shall pass” mindset is warranted.

Oil's starring role

The U.S.-Israeli military campaign against Iran, which began on February 28th, has already triggered what the International Energy Agency calls the largest oil supply disruption in the history of the global oil market. Global crude production is down at least eight million barrels per day; flows through the Strait of Hormuz have collapsed to less than 10% of pre-conflict levels, and roughly 7.5% of world oil supply has been knocked offline. The IEA’s member nations have responded with an unprecedented release of 400 million barrels from strategic reserves - the largest in the agency’s history. However, analysts note the stockpile releases could take 60 to 90 days to meaningfully reach the market and would only close about a quarter of the supply gap.

The oil market has reacted accordingly. Brent crude has spiked from about $70 per barrel in late February to above $100 shortly after the conflict broke out, briefly touching $116 per barrel intraday earlier this week. As of this writing, Brent has closed above $100 for the first time since mid-2022, with Iran’s new supreme leader publicly vowing to keep the Strait of Hormuz shut. The rule of thumb is that every $10 increase in crude adds roughly 20–25 cents to the cost of a gallon of gasoline in the U.S. American drivers are already feeling it: The national average price of gas has jumped from $2.98 per gallon at the end of February to $3.60 in just 12 days, according to AAA.

Whistling past the graveyard?

The S&P 500 has sold off since the start of the war, but the drawdown has been modest so far - roughly 3% as of March 12th. The credit markets are also unfazed. Investment-grade and high-yield spreads have barely moved, which is the clearest signal that fixed-income investors are not pricing in meaningful economic damage. The options-market implied volatility (VIX) has picked up, reflecting the elevated uncertainty, but the VIX spike has been modest compared to what we saw during last April’s tariff-driven “Liberation Day” sell-off. Long-term inflation expectations embedded in Treasury breakevens have been equally sanguine. The 10-year breakeven rate has barely budged. Even the 2-year breakeven, which has moved more noticeably, hasn’t surpassed the levels reached during the Liberation Day uncertainty. In aggregate, the U.S. market is telling us it expects the impact of this conflict on it to be temporary and contained.

International equity markets have been less forgiving. Non-U.S. stocks have experienced sharper drawdowns driven by greater direct dependence on Middle Eastern energy supply, sensitivity to U.S. dollar strength and a reversal of their strong prior outperformance versus U.S. equities.

The danger when oil is involved

The market’s resilience is not unusual in the face of geopolitical turmoil. Goldman Sachs, citing seven comparable episodes since 1950, found that the S&P 500 declined an average of 4% in the first week but recovered within the subsequent month. The buy-the-dip mentality has worked so reliably that many investors now treat geopolitical crises as opportunities rather than threats.

But there is a hazard to overreliance on averages. Outliers are real. The episodes that did produce lasting damage to markets were the ones that triggered lasting oil shocks. The 1973 Yom Kippur War and the resulting Arab oil embargo sent the S&P 500 down more than 40% over the course of the following year, kicked off a prolonged recession and ushered in a stagflationary period that took nearly a decade to fully resolve. Iraq’s invasion of Kuwait in 1990 precipitated a 17% drawdown.

In both exceptions, the distinguishing factor was not the military conflict itself but the sustained disruption to global energy supply and the inflationary consequences that followed.

Considering the range of outcomes

If the conflict ends within the next few weeks and the Strait of Hormuz reopens relatively quickly, then the market’s current reaction will be justified. A return of oil prices to pre-war levels should dull the inflationary impact and markets will likely recover losses in short order. This is the base case the market appears to be discounting.

If the conflict drags on, the dynamic changes considerably. A prolonged closure of the Strait of Hormuz could sustain crude prices well above $100 and potentially push them toward the $150–$200 range that some analysts have flagged. That is the kind of shock that feeds directly into headline inflation and increases the odds of a stagflationary scenario. Such an outcome would undoubtedly sour investor sentiment and cause a major pullback in risk assets.

Perilous timing

The threat of an oil shock couldn’t come at worse time. Market expectations for the U.S. economy and corporate earnings are running high, leaving risk asset prices particularly vulnerable to major shift in outlook. The trailing PE multiple for the S&P 500 Index is currently double what it was ahead of the Yom Kippur War. Adding to the downside risk, the Fed’s ability to cut rates in the face of weakening labor market will be impaired by sustained inflationary pressure.

None of this is meant to instill fear, but rather to illuminate the possibilities the market may be dismissing. At the very least, the market may be suffering from a degree of cognitive dissonance. Right now, markets are pricing in a high probability of the optimistic scenario and assigning very little weight to the tail risk of a prolonged disruption. That asymmetry deserves attention.

About James St. Aubin

Chief Investment Officer (CIO)James St. Aubin, CFA®, CAIA®, is Chief Investment Officer for Ocean Park Asset Management. He has oversight of all Investment Management department activities, in collaboration with Co-founders David Wright and Kenneth Sleeper. An experienced investment management executive, his career of more than 20 years includes leadership roles in asset allocation, manager research and portfolio construction. James earned a Bachelor of Science in Finance from DePaul University and is a CFA® and CAIA® Charterholder.

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