Summary
The escalation of conflict in the Middle East in late February has injected a level of uncertainty into global markets that investors have not faced since the early days of the pandemic. The US-Israeli strikes on Iran and the subsequent closure of the Strait of Hormuz – through which roughly 20% of global oil and a quarter of the world’s liquefied natural gas trade normally transits – have created one of the largest energy supply disruptions in the history of the modern oil market. At its most acute in March, global oil supply fell by over 10 million barrels per day – over 10% of daily supply.
Yet for all the severity of the initial shock, the global economy has demonstrated a degree of resilience that has surprised many observers. Equity markets, after sharp initial sell-offs, have recovered much of their losses – with the S&P 500 reaching fresh all-time highs in April, buoyed by robust corporate earnings, ongoing enthusiasm for artificial intelligence, and recurring hopes of a negotiated resolution. The pattern has been one of whipsaw volatility rather than sustained collapse, suggesting that markets are pricing a geopolitical risk premium rather than a permanent impairment of global growth.
The question that matters most now is what comes next. At the time of writing, a preliminary agreement to de-escalate tensions has been reached, although implementation remains uncertain and uneven. While there are early signs of shipping activity resuming, access through the Strait of Hormuz remains constrained and the outlook highly uncertain. The range of plausible outcomes – from a relatively swift normalisation to a protracted and fragile stand-off – remains unusually wide, with correspondingly varied implications for energy markets, inflation, monetary policy and the broader investment landscape.
The energy landscape: inventories, buffers and the race against time
Global oil inventories entered 2026 at a relatively healthy 8.4 billion barrels (vs ~100m daily global consumption) and this underappreciated surplus, in storage tanks and aboard ships, has cushioned the global economy since the Persian Gulf closed. Several buffers were deployed too. The International Energy Agency coordinated the release of 400 million barrels from strategic reserves – significantly larger than the 182-million-barrel release following Russia's invasion of Ukraine in 2022. Saudi Arabia has pivoted to land-based export pipelines, routing crude to the Red Sea coast, and Asian countries have secured energy supplies through alternative sources including the United States and Brazil. Analysis also suggests that demand destruction of ~4 million barrels per day is already occurring, driven by surging prices, slower economic growth, flight cancellations and voluntary consumption reductions.
These inventories and buffers have provided vital support, but not a permanent solution. The easily accessible portion of excess supply is dwindling and some oil analysts are predicting that a harsh reckoning could upend energy markets within weeks. A lot now hinges on whether a credible reopening of the Strait of Hormuz can be achieved – and how quickly improved traffic volumes can be restored.
Brent crude, which began the year below $60 per barrel, has traded in a volatile range of $80–$120 since the conflict began, with the International Energy Agency forecasting an average of around $86 for 2026 under its base case assumption of a gradual normalisation by late in the year.
Central Banks, inflation and the policy bind
The energy shock has upended the monetary policy landscape. Heading into 2026, markets had priced multiple rate cuts across developed economies. That expectation has been comprehensively reversed. The European Central Bank signalled that it was ‘moving away from the baseline’ increasing rates by 0.25% in June – with a majority of economists now expecting a further hike this year. The Bank of England held rates in June, but several committee members leaned hawkish, and gilt yields have risen aggressively – the 10-year yield has exceeded 5%, its highest since the global financial crisis. The Federal Reserve, meanwhile, remains on hold, though its bias has shifted decisively away from easing, with dissenting voices now audible within the committee.
Beyond the major Western central banks, tightening is already underway. Australia, the Philippines and Norway have raised rates in direct response to the energy shock. Colombia's central bank hiked by a full percentage point. Even where easing cycles had begun – in Brazil, Mexico and Poland – the pace has slowed materially, with policymakers explicitly citing geopolitical risk.
Euro area headline inflation has risen to 3.2%, with forecasts pointing to 3.4% for the remainder of the year. The United Kingdom, with its heavy reliance on imported energy and already persistent inflation pressures, appears particularly exposed.
The inflation dilemma is well understood: this is a supply-side shock, and conventional monetary tightening is a blunt instrument against cost-push inflation when the demand for energy is relatively inelastic in the short term. This causes elevated risk of policy errors. Raising rates in the face of an external supply shock risks compounding the damage to growth, without meaningfully addressing the source of inflation. However, central banks are acutely aware that their credibility was tested during the post-pandemic inflation episode, and the bar for tolerating above-target inflation is now higher than it was. The most likely path appears to be one of caution – modest tightening or hawkish rhetoric to anchor expectations, while retaining optionality to reverse course if growth deteriorates materially.
Beyond monetary policy, the conflict is adding to the fiscal pressures that were already building across developed economies. Defence budgets are rising structurally – global military spending reached $2.63 trillion in 2025, with Europe’s share climbing from 17% to 21% of the global total in just three years. The need to invest in energy security, accelerate the transition to renewables, and build strategic reserves all require public capital at a time when debt levels are already elevated. This tension between the imperative to spend and the constraint of fiscal sustainability is likely to be a defining theme for sovereign bond markets in the years ahead.
The impact is far from uniform across the global economy. Emerging market oil importers face an even more punishing set of dynamics: deteriorating trade balances, capital outflows, currency depreciation and higher borrowing costs. India's rupee has fallen to record lows, and frontier market sovereigns including Kenya, Pakistan and Sri Lanka have seen sharp spread widening. On average, every 10% rise in crude oil prices trims emerging market GDP growth by approximately 0.5 percentage points while lifting inflation by a full percentage point.
Gulf economies: adapting under pressure
The Gulf Cooperation Council economies face a sharp and complex shock, where higher oil prices are offset by physical constraints on exports, alongside severe hits to tourism and aviation, undermining key diversification sectors; this has driven a marked deterioration in the macro outlook, with IMF estimates pointing to MENAP growth slowing to 1.4% in 2026 (down 2.3ppt) and several Gulf exporters facing outright contractions, and GDP downgrades of up to 15 percentage points, even if conditions normalise later in the year.
These challenges are likely to impact the investment strategy of Gulf sovereign wealth funds. These institutions collectively manage trillions of dollars in global assets and have been among the most active investors in technology, infrastructure and energy transition projects worldwide. The need for increased defence spending and massive capex costs to repair and reroute energy infrastructure, may redirect capital flows in ways that global markets have not yet fully priced.
The shifting geopolitical architecture
The conflict has implications that extend well beyond energy markets. It is accelerating a reconfiguration of global alliances and security arrangements that was already underway. Europe’s defence spending surge – now approaching NATO’s long-discussed 3.5% of GDP target for several member states – reflects a recognition that the continent can no longer rely on American security guarantees to the same degree.
The imperative for energy independence has moved from a long-term strategic objective to an urgent policy priority. European natural gas prices surged sharply in the early weeks of the conflict — a painful echo of the 2022 experience following Russia's invasion of Ukraine, albeit from a stronger starting position in terms of storage levels. Renewables, nuclear energy and LNG diversification are all receiving renewed fiscal and political support. The intersection of energy security, climate policy and defence spending represents a significant call on public finances across the developed world — one that will need to be managed alongside already-elevated debt levels and the fiscal demands of ageing populations.
Geopolitical fragmentation is increasingly being recognised as a structural mega force rather than a cyclical phenomenon. Supply chains are being redesigned for resilience rather than efficiency. Energy systems are being rebuilt for sovereignty rather than cost optimisation. Defence architectures are being upgraded for sustained deterrence rather than episodic intervention. These shifts have profound and lasting implications for capital allocation, government finances and the trajectory of globalisation — and they are unlikely to be reversed even if the immediate conflict is resolved.
What this means for investors
For investors, the temptation in moments of geopolitical crisis is to make binary bets – such as retreating to cash. History suggests impulsive decisions are not well rewarded. Analysis of major geopolitical escalations since 1990 shows that equity markets have typically recovered within one to three months, with the S&P 500 posting gains in the month following the onset of hostilities. Credit spreads have tended to tighten, not widen, beyond the initial shock. The current episode, while more severe in its energy market impact than most precedents, appears to be following a broadly similar pattern.
That said, there are reasons for caution. The range of outcomes remains exceptionally wide, and the risk of a more protracted disruption – with oil prices potentially rising further from current levels – cannot be dismissed. A sustained energy shock of that magnitude would materially worsen the inflation outlook, force more aggressive central bank tightening, and raise the probability of recession in Europe and parts of Asia.
Diversification, both across asset classes and geographies, remains the most reliable tool in an environment of elevated uncertainty. Commodities, which sit close to the source of the inflation impulse, have demonstrated their value as a portfolio diversifier in precisely this type of scenario. Real assets and inflation-linked securities offer a degree of protection that traditional fixed income does not when headline inflation is accelerating. Within equities, the dispersion of outcomes across sectors and regions has widened – energy, defence, and renewables have outperformed, while consumer-facing sectors and energy-intensive industries face greater pressure.
It is also worth stepping back from the immediate crisis to consider the structural forces that will shape asset returns over the medium term. The artificial intelligence investment cycle continues to gather momentum, with US technology companies expected to spend over $700 billion on AI infrastructure in 2026 alone. This represents a powerful secular growth driver that exists largely independently of the geopolitical cycle. Corporate earnings have remained resilient – US first-quarter earnings growth came in well ahead of expectations – suggesting that the productive capacity of the global economy has not been fundamentally impaired.
The most constructive framing may be to view the current environment as a stress test rather than a derailment of broader economic momentum. The global economy entered 2026 with solid fundamentals – healthy corporate balance sheets, resilient labour markets, and a technology-driven productivity story that has further to run. The energy shock is a genuine headwind, and the uncertainty around its resolution demands prudence. But it is not, on its own, sufficient to derail a global economy that has demonstrated a remarkable capacity to adapt.
Continued vigilance is warranted. The trajectory of the conflict, the pace at which energy flows normalise, and the policy responses of central banks will all be critical determinants of the outlook in the months ahead. Investors could be well served by maintaining a diversified approach, resisting the urge to make large directional bets on the basis of headline news flow, and keeping a close eye on the data as it evolves. Geopolitical shocks, for all their drama, have historically been moments that create opportunities as well as risks – and the current episode is unlikely to prove an exception.
This content has been prepared by the Life Investment Office (LIO) for information purposes only and does not contain or constitute investment advice.
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