What we know

 

The U.S. military over the weekend successfully struck three nuclear sites in Iran: Natanz, Isfahan, and (most importantly) Fordow. Seven B-2 bombers carried out the strikes, dropping a total of 14 MOPs (Massive Ordnance Penetrator) on Fordow and Natanz. It marked the first use of the GBU-57 MOP “bunker-buster” bombs in conflict. Isfahan was hit with more than two dozen Tomahawk missiles fired from a U.S. submarine. The scope of operation was intentionally limited to nuclear facilities.

 

While there were mixed messages around the timing (perhaps strategically), the potential for a U.S. attack was well-flagged and for now is being communicated as a one-and-done successful mission that has set Iran’s nuclear ambitions back years.

 

The U.S. claims the attacks were successful and sites were “obliterated” while Iranian officials suggested the damage was “not irreversible”. The International Atomic Energy Agency hadn’t detected an increase in radiation outside the sites.

 

Iran warned there would be consequences for U.S. strikes on its key nuclear sites and said it “reserves all options,” while showing restraint in its initial response.

 

Iran’s foreign minister Abbas Araghchi met with Russian President Vladimir Putin on Monday. China’s foreign ministry said it strongly condemns the attacks and calls on the parties to reach a ceasefire as soon as possible.

 

U.S. President Donald Trump has not ruled out further attacks, threatening even greater force if Iran retaliates, although his preference is for a negotiated settlement.

 

 

Market response

 

How markets ultimately react and settle likely hinges greatly on Iran’s response. As of Monday morning, equities were flat to up, while oil and the U.S. dollar were flat. All things considered, we think the market’s immediate reaction isn’t pricing in a worst-case scenario.

 

While we expect knee-jerk safe-haven rallies in oil, Treasurys, the dollar, and gold, we don’t expect major market dislocations save material re-escalation. The fact the U.S. took relatively limited action (as opposed to a broader bombing campaign against the entire Iranian military and political infrastructure) could act as an off-ramp to de-escalation.

 

It’s also interesting to observe the local stock market reaction. Middle East stocks rose, led by Israel and Egypt, as the region’s traders bet the U.S. intervention in the Iran conflict will accelerate a resolution to the nuclear tension. Israel’s stocks rose and are up more than 20% this year, hitting record highs. Saudi Arabian stocks have also risen but interestingly Saudi Aramco, the largest oil company in the region, is flat/down, suggesting the market is not expecting much change in oil prices.

 

The market’s limited reaction could also be very telling. Is the market suggesting we are nearing the end of this conflict rather than the beginning of something bigger? Only time will tell.

 

On one side of the argument, Iran’s leadership has made it clear they have no intention of backing down and have threatened retaliation. Russia’s Deputy Security Council has stated that foreign governments are prepared to supply Iran with their own nuclear warheads, only fueling the Ayatollah’s rhetoric.

 

The other side can argue that Iran’s military capabilities have been extremely degraded following Israel’s attacks, its proxies (Hezbollah and Hamas) have all but been neutralized, its economy essentially in free fall, and growing unrest within Iran is only adding internal pressure. All this while recognizing Israel stating their job is not yet complete, and have called for a full regime change in Iran — something Trump has explicitly endorsed on Sunday in one of many social media posts, a notable one saying it’s time to “MAKE IRAN GREAT AGAIN.”

 

Whether an off-ramp exists to de-escalate the situation, perhaps markets are trying to price in the possibility that regime change seems inevitable and, along with that, investors need to consider the right tail risk of positive developments in addition to the left tail risk of negative developments.

 

 

What to watch

 

The situation remains fluid and how Iran responds will have profound consequences, not only for the U.S. but also for the capital markets and global economy. While Iran likely will retaliate, it will be the degree to which that defines the outcome.

 

Should Iran hit back against U.S. troops or citizens, the conflict could quickly escalate. We think Trump would almost certainly stick to his word and launch further attacks, only this time not limited in scope to nuclear facilities.

 

Another possible (and consequential) scenario — given its likely impact on oil prices — would be the closure of the Strait of Hormuz. News reports indicate that Iranian parliament has given support to close the Strait, although no final decision has been made. This would certainly cause oil prices to spike and reverberate throughout the global economy.

 

Most commentators see blocking the Strait as being unlikely, as are attacks on energy infrastructure in the Persian Gulf.

The U.S. has amassed a massive military presence in the Gulf and surrounding region, and a move by Iran against the Strait would almost certainly trigger a significant military response and anger oil exporters in the region like Saudi Arabia. Blocking the Strait would also negatively impact China, one of Iran’s remaining key allies. Betting markets vary widely on this, giving a 20% to 50% chance of a blockade by year-end.

 

Iran is unlikely to escalate against energy targets while its own energy export facilities remain intact. However, increased Iranian harassment of tanker traffic is likely in coming days, as are cyberattacks.  

 

 

Investment Implications

 

In our tactical model portfolio, we are neutral to U.S. equities after recently paring the allocation. We remain overweight developed-market equities outside the U.S., and would lean into weakness save any escalation.

 

We’ve also increased our weighting to cash, inflation-linked securities (TIPS) and infrastructure, positioning against the risk of higher energy prices (and inflation).

 

If little else, these tragic events serve as a reminder of the importance of portfolio diversification, and cash liquidity.