Within one hundred hours, American and Israeli forces struck nearly 2.000 targets in Iran. Ayatollah Khamenei and dozens of senior officials were killed. It is the largest American military operation in the Middle East since 2003. The initial market reaction was remarkably muted, but the oil price tells a different story.
The cost of a barrel of Brent oil rose last week from 67 dollar to more than 92 dollar per barrel, the largest weekly increase in the history of this future. Earlier this week, the oil price climbed above the symbolic level of 100 dollar per barrel. The Strait of Hormuz, roughly as wide as the Strait of Dover and responsible for a fifth of the global oil and LNG supply, is effectively closed. Not because of a formal blockade, but because insurers and shipowners are fleeing. Iraq has shut down 1,5 million barrels per day, Kuwait has reduced production, and Qatar has declared force majeure on gas exports.
Four scenarios
The most likely scenario is that the regime will be largely disarmed but remains in place. The internal unrest in Iran, which until recently had already cost 36.500 lives in two days, continues under the new supreme leader Mojtaba Khamenei.
The second scenario is the collapse of the Islamic Republic, followed by a transition to a pro-American administration. Such a revolution is still seen as impossible today, but afterward it will be seen as inevitable. The regime may appear strong and stable, but every crisis one can imagine is present in Iran. Many Iranians have nothing left to lose.
A third scenario is that the remaining leadership will reach a commercial deal with the US, comparable to what happened in Venezuela. A ceasefire without a deal has a much smaller chance, but becomes more likely the longer the conflict continues and the more pressure builds on the American stock market.
The least likely scenario is that Russia or China intervene militarily to support Iran. Russia has limited capacity, and China has deep trade relations with Iran’s rivals in the Gulf.
High probability of de-escalation
What stands out in these scenarios is that in four out of five cases the conflict is contained within a foreseeable period. The probability of some form of de-escalation is high. That is not a coincidence, but the result of rational incentives on all sides. For the US, the costs are rising rapidly. One hour of flying with an F-35 costs 45.000 dollar. Intercepting an Iranian drone worth 30.000 dollar with a Patriot missile costing 4 million dollar is an asymmetry that becomes unsustainable in a prolonged conflict. American war costs are already estimated at 100 billion euro. Moreover, 60 percent of Americans disapprove of the military action, and gasoline prices have already risen sharply.
For Iran, the situation is even more dire. The leadership has been decimated, the economy was already fragile with inflation above 40 percent, and the population has been hostile to the regime for years. Even for China and Russia, escalation is irrational. Both have more to lose than to gain from a disruption of oil supplies from the Gulf.
Shifting leadership
Beneath the surface of the market, a sector rotation had already been underway before the conflict. Leadership had shifted from the Magnificent 7 toward value, dividend stocks, smallcaps, and defensive sectors. The war is reversing that movement, and software stocks are recovering. Historically, oil shocks have only led to stock market corrections of more than 15 percent if at least one of the following three conditions was met: a price increase of 50 to 100 percent that lasts for months, an economy moving toward recession, or sharp tightening by the central bank.
In concrete terms: for serious damage to the American economy, WTI would need to rise toward 140 dollar per barrel and remain there for several quarters. At this moment, that is not likely, and the other conditions are just as unlikely—provided the conflict does not escalate. The incentives point in the opposite direction. For Europe and Asia, which are more heavily affected by higher energy costs, the outlook is less favorable.
The stock market punishes uncertainty
Anyone studying the history of geopolitical shocks and equity markets sees a remarkably consistent pattern. The S&P500 has historically delivered an average return of 12 percent in the year following major geopolitical crises. After the Iraqi invasion of Kuwait in 1990, the S&P500 lost 16 percent in three months, but six months later it had already risen above its pre-invasion level. Even after September 11, 2001, the market recovered to its pre-attack level within five weeks.
The pattern is always the same: a sharp decline driven by uncertainty, followed by recovery once the contours of the outcome become visible. The stock market does not punish geopolitical conflicts; it punishes uncertainty. Once uncertainty declines, capital returns. That is exactly why de-escalation is not only the most likely scenario, but also the scenario that becomes priced in once the initial panic subsides.
De-escalation is the most likely scenario, but “likely” is not the same as “certain.” Iran has 125.000 professional soldiers in the Revolutionary Guard and a paramilitary network of 10 million registered volunteers present in virtually every city and university. There is no organized opposition ready to take power. A swift and orderly outcome is therefore not guaranteed. The war in Iran is deadly serious. But the rational outcome is de-escalation, and in the longer term markets follow rationality.
Han Dieperink is chief investment officer at Auréus Vermogensbeheer. Earlier in his career he was chief investment officer at Rabobank and Schretlen & Co.