Our Deputy Global Head of Research Michael Zezas and Head of
Public Policy Research Ariana Salvatore assess the potential
market outcomes of the Middle East conflict, weighing its
possible duration and economic impact.
Read more insights from Morgan Stanley.
----- Transcript -----
Michael Zezas: Welcome to Thoughts on the
Market. I'm Michael Zezas, Morgan Stanley's Deputy Global Head of
Research.
Ariana Salvatore: And I'm Ariana Salvatore,
Head of Public Policy Research.
Michael Zezas: Today we're discussing the
escalating U.S.-Iran conflict, the market reaction, and what
investors should be watching for next.
It's Wednesday, March 4th at 7:30am in San Francisco.
Ariana Salvatore: And 10:30am in New
York.
Michael Zezas: So, Ariana, I'm in San
Francisco at Morgan Stanley's TMT Conference, but obviously
events in the Middle East have captured everyone's attention.
There's uncertainty around the conflict and really important
questions about how it affects all of us. And of course, markets
have to discount all sorts of future uncertainty about very
specific impacts – to financial asset prices, to commodity prices
– and really look at it through that narrow lens.
And so, Ariana, the administration has suggested that this
conflict and this campaign could last a few weeks. But also it
said it could continue as long as it takes. So, what are the
clearest signals investors should watch for to gauge
duration?
Ariana Salvatore: For now, we're focused on
three main indicators. First, I would say, and most important, is
clarity around the objectives. The president and others in the
administration have referenced things like eliminating Iran's
missile arsenal, its navy and limiting proxy activity. Those
goals are broader than the earlier focus on just the nuclear
programs. Each objective, of course, implies a different
timeline. A narrower objective likely means a shorter engagement.
Broader ambitions, conversely, would extend it. So that's the
first thing.
Second, obviously extremely important is traffic through the
Strait of Hormuz. We'd viewed a full closure as unlikely, given
the economic consequences for Iran itself. But tanker flows have
at least temporarily fallen close to zero, and that's significant
because production across the region has not been impaired. This
is not about oil fields going offline. It's about whether or not
oil can actually move. If shipping lanes normalize within weeks,
markets can recalibrate. However, if flows remain materially
curtailed beyond five weeks, the risks rise meaningfully.
Third, the frequency of strikes and proxy activity. Sustained or
escalating engagement would suggest a longer conflict. Signs of
diplomacy, on the other hand, might indicate de-escalation.
Michael Zezas: Right. So, let's build on
that and talk about oil. And our colleague, Martijn Rats has
really laid this out with a lot of different scenarios. But what
we're seeing right now is that when it comes to oil, this is
really a shock to the transport of it, not necessarily a shock to
its production. So, oil supply exists. The question is really –
can it be delivered or not?
So, if tanker flows normalize and the geopolitical risk premium
fades, what Martijn is saying is that global oil prices could
move back towards $60 to $65 a barrel. If the logistical
disruption lasts four to five weeks, then prices maybe trade in
the $75 to $80 range. And if disruption extends beyond five weeks
and flows are materially constrained, then you could see a
situation where oil prices have to rise towards $120 or $130 a
barrel. And at that level, demand destruction is what becomes the
balancing mechanism in setting price for oil.
So, one signal to watch is longer dated oil prices. Early month
contracts can spike during geopolitical stress, but a sustained
move materially above $80 to $85 [per] barrel would likely
require longer dated prices to move higher as well. And that
might signal that markets believe the disruption is persistent
and not temporary.
Ariana, what about natural gas here? How does gas situation fit
into the energy story?
Ariana Salvatore: As of this recording,
Qatar has halted liquified natural gas production putting roughly
20 percent of global supply at risk. Prices have, as you might
expect, risen sharply, which likely reflects expectations of a
relatively short disruption. If exports were to resume quickly,
prices could retrace. But, of course, if the outage lasts longer,
prices could move meaningfully higher. Again, duration of the
conflict is really critical here.
Michael Zezas: So, let's bring this back to
the U.S. Ariana, how does this conflict feed into the domestic,
political and economic backdrop?
Ariana Salvatore: When we're thinking about
the midterm elections later this year, the way we see it, the
clearest transmission channel is gasoline prices. Polling shows a
majority of Americans oppose military action related to Iran, but
voters typically prioritize domestic issues: things like
inflation, cost of living, affordability over foreign policy.
However, there's a very clear caveat here. If oil prices stay
elevated, gasoline prices rise, and that's where this becomes
politically more salient.
Michael Zezas: Right, and so our economists
and our chief U.S. Economist Michael Gapen has been all over
this. And the way he assesses it is if oil prices remain about 10
percent higher than where they were before the conflict for
several months, headline inflation would likely rise by 0.3
percent before dissipating. Historically, oil price shocks
primarily affect headline inflation rather than underlying
inflation. That's an important distinction that they point
out.
So maybe that could delay Federal Reserve rate cuts, even if
policymakers ultimately look through the move. But if oil prices
rise enough to weaken economic activity, particularly in the
labor market or consumer spending, then our economists say the
Fed could pivot toward easing despite elevated inflation.
Ariana Salvatore: So, given that backdrop,
what's the simple takeaway for investors in stocks or
bonds?
Michael Zezas: Right. So, I think we have
to think about this in terms of duration of conflict and economic
impact. So, if tanker flows normalize within a few weeks and oil
prices move back towards that $60 to $65 range, then our
economists are saying economic damage would be limited. And
historically geopolitical events alone have not led to sustained
volatility for U.S. equities. So, in that environment, our
cross-asset team points out that stocks would likely remain
supported.
If instead, oil prices remain elevated long enough to push
inflation higher and weigh on growth, the picture would change. A
sharp and persistent rise in oil prices – that can pose a risk to
the duration of the business cycle, and in that scenario, we'd
expect stocks to struggle.
Importantly, bonds may not provide the same diversification
benefit if inflation remains sticky as a consequence of all of
this. We could see stock and bond prices move in the same
direction. That could challenge traditional balanced
portfolios.
Ariana Salvatore: And what are we seeing
specifically in U.S. Treasury markets?
Michael Zezas: So, as Matt Hornbach and our
global macro strategy team have pointed out here, you've got two
competing forces in the U.S. Treasury market. There's been some
demand for safety, but investors are also focused on the risk
that higher oil prices would lift inflation. So far, inflation
concerns have taken precedence over growth concerns. How long
that balance holds – that might depend on incoming data,
especially labor market data.
If you get weaker labor market data suggesting that growth could
weaken, then you could see treasuries rally more meaningfully and
yields come down. If you don't see that and inflation concerns
dominate, then maybe you're not going to see yields come down as
much. And bonds rally as much.
Ariana Salvatore: So, stepping back, it
seems like the key variables remain tanker traffic, longer dated
oil prices and duration of the conflict itself.
Michael Zezas: I think that's right.
Ariana, thanks for speaking with me.
Ariana Salvatore: Always a pleasure,
Mike.
Michael Zezas: And thanks to our listeners
for joining us. We'll continue tracking developments and what
they mean for markets. If you enjoy Thoughts on the Market,
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