Top of the Morning: CIO Strategy Snapshot - US-Iran conflict: Assessing the market & macro impacts
The current US-Iran conflict introduces significant uncertainty into energy markets, likely sustaining upward pressure on oil prices, which the Federal Reserve may consider in its upcoming policy decisions. Per the full note from UBS, the situation remains fluid, with the potential for further escalations that could negatively influence global economic indicators. Market participants are closely monitoring this geopolitical strife alongside domestic economic data that could shape monetary policy. This backdrop frames a cautious outlook as investors evaluate oil's role in inflation dynamics and Fed response strategies.
What the desk is arguing
The desk interprets the ongoing US-Iran conflict as a catalyst for potential inflationary pressures through higher energy prices. Per the full note from UBS, the recent US air strikes on Iran's oil infrastructure and threats towards oil shipping routes are escalating tensions and could sustain elevated oil prices for an extended period.
The desk also points to the Federal Reserve's upcoming FOMC meeting, where central bank officials are expected to weigh the implications of rising oil prices on inflation forecasts and economic growth. As energy prices impact consumers and businesses alike, any policy shifts will be pivotal in determining market stability moving forward.
Where it sits in our coverage
While we have no internal coverage data on relevant currency pairs, professionals should note the increased volatility expected in energy-related currencies as traders react to the geopolitical situation and potential Fed responses.
How other firms see it
Consensus among firms indicates concern over sustained oil price increases, with some firms positioned to benefit from inflationary outcomes while others remain more cautious. jpmorgan appears aligned with a bullish outlook, while bofa is more reserved, indicating the divergence in trader sentiment.
Tracking energy-sensitive currency pairs will be essential, as a spike in oil prices may influence market dynamics in currencies such as CAD/USD or NOK/USD, paralleling shifts in central bank policy direction.
What the calendar says
With no major events scheduled in the immediate future, focus remains on the potential for reactive analyses post-FOMC outcomes, particularly how the market reconciles Fed statements with ongoing geopolitical tensions.
01US-Iran conflict likely to sustain upward pressure on oil prices.
02Fed's FOMC meeting will discuss implications of rising energy costs.
03Market participants are highly reactive to geopolitical developments.
04Watch for shifts in energy-sensitive currency pairs.
Market implications
Traders should monitor WTI and Brent crude prices closely for significant movements that may affect currency pairs like CAD/USD and NOK/USD. Key resistance levels for oil prices will be critical to observe as they may directly impact inflation forecasts and thus market sentiment towards the Fed's policy stance.
Risks to this view
A de-escalation in the US-Iran conflict or a significant increase in US domestic oil production could lead to a reversal of the upward price trend in energy markets. Additionally, a shift in Fed policy that does not reflect concerns over oil prices may prompt a recalibration in investor expectations.
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Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. We are now in the third week of the U.S.-Iran conflict and investors remain focused on how long it could last and the potential economic consequences.
Now there are other developments relevant for the investment outlook, including economic data and how the Fed incorporates the oil price shock into its decision-making at the FOMC meeting this week. So joining us here on this Monday morning to discuss this all for the CIO Strategy Snapshot, glad to welcome back Head of Asset Allocation for the Americas from the UBS Chief Investment Office Jason Draho. Jason, a lot has of course taken place since you and I last spoke, so it's great to have you back on the podcast today.
Thank you for joining our listeners and our clients on this Monday morning. Good morning, Dan. Happy Monday.
It's been a couple of weeks since we talked and obviously a lot has happened during that time period. So with that, Jason, perhaps geopolitics a good place to start. Can you bring our listeners up to speed as far as CIO's latest thinking on the U.S.-Iran conflict, when it might be resolved, and the outlook for oil? lead to a sustained rise in energy prices, even if the events remain uncertain, at least for the next couple of weeks if not a little bit longer.
If you look at what happened just over the past few days over the weekend, on Friday the U.S. bombed military targets on Iran's main oil export hub on Karg Island, and President Trump threatened additional strikes. Can you target Asian facilities if Tehran doesn't or needs to block the street of Hormuz and warn Iran that there could be more consequences of attacks on its energy infrastructure? Trump has also said in a statement that the U.S. has achieved its military objective and is now seeking international support to reopen the straits.
We can interpret that as an indication that the U.S. is ultimately looking for an off-round. I know quite a turn on the Wall Street Journal, the Trump administration does plan to announce this week that it has formed a coalition with a number of companies to help escort ships through the straits. While the uncertainty remains high, the administration looks like they want to still have this resolved within four to six weeks, which was the initial time frame laid out by the President two weeks ago.
Just as a positive note to reinforce his view, two tankers carrying liquefied petroleum gas to India did go through the strait over the weekend. So there is some signs of at least a complete shutdown. Ultimately, though, in terms of going back to the price of oil, the situation is very much in flux.
The combination of the supply disruptions and the limited offset from increasing the releases from the strategic reserves means that oil prices are likely to stay higher for longer, even if the flows through the Strait of Hormuz resume within a few weeks. As a result, our commodities team has upgraded their price targets for Brent crude and now expecting it to be $90 a barrel at the end of June. This is up from $65 and then it falls to $85 by the end of September, $85 in December, then down to $80 by next March.
So it will take a while for this to normalize. These are the prices for Brent at WTI in the U.S. It's always said to be a little bit lower, but likely to be about $4 or $5 lower per barrel.
So a level shift higher of almost $15 to $20 across the time horizon that we're talking about. So even if this disruption gets resolved, roughly assuming within the next month, just the fact that these strategic reserves will be drained and last week OECD countries agreed to release 400 million barrels from their strategic reserves. As they release those, it takes not only them to rebuild it, but that also augments the demand overall for oil and all that leads to higher oil prices going forward.
These forecasts assume that the straight will resume by end of March, early in May or early in April. If the disruption lasts longer, then ultimately you can see Brent going all the way to $150 a barrel. So ultimately you would need some demand destruction to curtail demand to bring prices lower.
So there are certainly risks of going higher in near term. The idea that we get back to price levels that existed just a month ago, that's not going to happen anytime soon. So the situation may resolve in terms of this oil impact and oil disruption to the supply relatively soon, but the impact for higher oil prices are likely to linger through much of this year into early next year as well.
Now, one of the key questions, Jason, is how the surge in oil prices could impact the economy. What is the risk and what does the current data say about the state of the economy? Well, if we think about the potential risk to the economy from high oil prices, there's a general sort of rule of thumb that a sustained increase in the price of oil by $10 per barrel would drag down GDP growth by about 10 basis points, all is equal.
And so if you think of oil's data, it's roughly the 85 and 90 range versus 65 prior to that, let's say that's $20 a barrel higher and it's sustained throughout the rest of this year, that could drag down growth ultimately 10 to 20 basis points. That's historical relationships. Over time, the U.S. has become more energy independent.
It's the largest oil producer in the world. And so sometimes high oil prices will affect consumers, can benefit producers. It's unlikely if prices do start to moderate that you're going to see much of a ramp up in production.
But the U.S. versus some other economies, certainly in Asia, to Europe to some extent, because of this sort of relative energy independence, is a little bit more immune to higher oil prices overall. But it's still negative. It's still inflationary.
It's still sort of a static inflationary shock, which can reflect the market performance of light. If we hold constant, you know, the oil dynamics and what's happening there and the potential impact going forward, if you actually look at the recent data, it is still consistent with the base case that we had that growth would be around 2.5% this year, give or take a tenth or two, measured by kind of a fourth quarter this year versus fourth quarter last year. Last week, there was GDP data for the fourth quarter, a revision to it, and it was revised lower by 70 basis points, you know, down to 0.7 from 1.4%.
And this was revised lower due to kind of exports being revised lower, consumer spending also following. But just to put it in context, consumer spending, if you look at the consumer overall, it went from 2.4% to 2%. And real domestic final sales growth, which kind of strips out the noise from exports from inventories, was still 1.9%.
So still relatively solid private sector demand, although that is a step down from where growth was in the second or third quarter of last year. Then we look at more real-time data. You know, the jobs report that we got for February was weak.
It came in at minus 92,000 in terms of job growth, when the consensus was about expecting plus 55,000. But if you take a step back and look at the labor market picture overall, some of the weakness in February could reflect sort of a payback from January being so overstated. There's a lot of seasonal issues with the January jobs data.
And if we look at sort of a three and, you know, four-month kind of moving average, it looks like not necessarily a trend shift lower, you know, but just a continuing sort of soft labor market. And other indicators such as, you know, jobless claims or announced job openings, you don't show real uptick in job losses, which suggests that the unemployment rate is likely to kind of still stabilize around the current level, like say 4.3% to 4.5%, you know. One of the reasons why we were optimistic on growth this year instead of acceleration is that the benefits of the stimulus package from last year, the one big beautiful bill should be kicking in.
Something that we're tracking closely is the tax refunds. They're expected to be larger this year, you know, given that the tax cuts were retroactive. You know, as of about a week ago, they were up about $13 billion year over year.
An average refund looked to be about up 11%. The data, though, is tracking the lower end of the estimates of between $50 to $100 billion in terms of sort of tax refunds, incremental to above and beyond what is normally done. So what it looks like, though, is it's likely to be maybe later in the season, so more of a 2Q story in terms of growth impact rather than the first quarter story, as opposed to the overall sort of stimulus benefit being kind of lower than initially anticipated.
When we get that sort of benefit of the tax cuts but also lower tax payments kind of going forward, we expect that job growth will rebound to some extent and supported by a firmer kind of growth outlook. So putting the big picture, if we abstract what's going on from, you know, the higher oil prices due to the conflict in the Middle East, you know, the macro story is playing out largely as kind of we expected. The labor market is yet to kind of improve, but it's not necessarily getting any worse despite the February data.
And the stimulus benefits, including accelerated investment, should lead to, you know, pickup and growth in the second quarter. That should support job growth going forward. Now, as far as how the Fed may be assessing this all, the Fed, of course, does meet this week to decide on changes to interest rates.
This in light of the higher oil prices. Jason, what are you expecting from the meeting this week? And how could oil impact the Fed's rate cutting decisions?
Well, higher oil prices certainly doesn't make the Fed's life any easier because it is going to be an inflationary shock. It's one of the reasons why, if you look at market pricing, it's now down to only one cut this year, and that is going to occur until December. If you think about where we were in early January, it was close to two and a half to three cuts in the first full cut, you know, bought by June.
And now that's definitely been pushed out. Ultimately, we still expect the Fed's going to cut to twice this year, June to September. You know, the risk is that this could be delayed a little bit.
But the rationale for this ultimately is the inflation impact, especially to core inflation from, you know, higher oil prices, is relatively modest. And using that sort of theme, kind of rule of thumb for growth, a $10 increase in the barrel of oil for a sustained period of time should translate into about four basis points higher of core inflation. And for a headline, if it would be higher, it could be closer to 20 basis points.
So we're going to kind of look through that and focus on core inflation. The underlying trends for inflation, by and large, still seem to be moving in the right direction. Shelter inflation is going lower.
Some of the good inflation, you know, showed, you know, an uptick in February. That is kind of consistent with the, you know, the tariff stores still having an impact. And we think that's going to, you know, kind of still to play out and work its way through the system, you know, by the end of the second quarter.
But nonetheless, higher inflation doesn't make it easier for the Fed to cut. But, like, the market price seems to be a little bit overreacting. Ultimately, the Fed has a dual mandate, both higher inflation and job growth.
And so while there's a risk of higher inflation, at least the headline numbers for an extended period of time, because of oil prices, the February jobs data, as much as we can try to suggest that, you know, still, you know, applying a stabilized labor market, does highlight the fact that there is significant downside risk to the labor market. And so from the Fed's perspective, and something that Jay Powell might say during his press conference at the end of the FOMC meeting, is that the risks were unbalanced. Inflation risks have increased, but also labor market risks have also increased to the downside.
And so you get it all out. The Fed's outlook, you know, remains kind of relatively, you know, balanced. So as a result, in terms of what to expect for the Fed this meeting, you have no rate cuts.
They may, well, likely can update their economic projections to show slightly higher inflation, slightly lower growth for 2026, slightly higher unemployment rate. You know, what you would get from a sort of a negative supply side shock. The median and dot at the December meeting applied one cut this year.
We expect that to be the same, you know, this time as well. It'll require pretty big change among different committee members to shift that median from one cut to either no cuts or very unlikely goes to two cuts at this point in time. So largely kind of status quo meeting and the Fed is going to operate in a bit of a fog.
Powell will probably reiterate that point. And just regarding some of the market pricing, it's priced out a lot of cuts this year, or at least push things further back. This has also occurred last week, largely the week in which it's part of this blackout period going into the FOMC.
So there was no Fed officials able to kind of talk back and push back against the market pricing. And so Powell's comments could sort of challenge some of that view. And you could see the market then sort of reprice back some of these cuts to sort of pull them forward after the FOMC and after the Fed that indicates its willingness to perhaps look through the, you know, the Fed meetings.
In terms of the cuts, you know, we're maintaining our view of June and September. And there's basically, you know, two paths for the Fed to get there. One ultimately is that it's an inflation story, that inflation, you know, trends look like they're moving in the right direction.
So that core goods inflation over the next three to six months, you know, looks like they have peaked. And by the time they get to the June meeting, they'll have May data. And from March to May, that could look a lot better.
So if they don't, you know, put too much emphasis on oil, then core inflation could fall enough for them to justify cutting in June. Another factor for them to be able to cut in June is if we get another one or two months of weak jobs numbers, you know, higher unemployment rates, you know, that could override the inflation data. So there's different paths for the Fed to be still cutting in June.
I think the market has become a little bit perhaps too pessimistic on that prospect. So let's end, Jason, on investment recommendations. What are the key messages at this time from the UBS Chief Investment Office and how should investors navigate market turbulence?
Well, let me start with just reiterating the macro view that we had for this year of, you know, solid growth, kind of with growth accelerated in the first half, a Fed that is still biased towards cutting twice this year. You know, so far, we don't think that view has materially changed or what's developments for the past two weeks haven't materially changed that outlook. And those are supportive conditions for risk assets and equities in particular to do well.
So I think for that reason, you know, if we take a medium-term view, like a full-year view, we still remain kind of optimistic on that. But we have to acknowledge that in the near term, uncertainty remains high. The markets could react to any sort of news flow and will react to any news flow regarding potentially either opening of the straight-up home moves or further disruptions that could take kind of longer.
And there's certainly a downside risk if the perceptions are this will not reopen in the next, let's say, within the next month. It does look like investors tend to be in a position to have gotten kind of closer to neutral. And by and large, I think there's a lot of investors who, during the first week of this conflict, were sort of relatively sanguine and thought that the President would ultimately kind of step back on terms of his actions.
You know, if the market and the economic implications became too negative, after the second week, and the sentiment on that got a little more pessimistic, not that, you know, the Trump administration is not aware of the economic considerations. But unlike, say, with tariffs, where they can unilaterally take action, this situation with Iran is not unilateral. They have to kind of also respond to what Iran does.
And so I think there's a little bit more pessimism that has creeped into the markets as a result. And you're seeing something on the market performance reflect that. And that could be, you know, investors in the markets overall can be very sensitive to any news over the next few weeks on this regard.
As a result, you know, we continue to sort of believe that the best way to navigate this environment is to make sure that you're sort of diversified across different asset classes, sectors, and regions, something that we've been advocating way back, you know, prior to these developments. You know, looking at other sort of, you know, hedges, you know, such as capital preservation strategies, you know, continue to like gold and commodities as sort of, you know, diversifiers, as a way to sort of, you know, kind of navigate through this environment. I think the key thing is the overall medium-term message, you know, remains kind of constructive.
And investors shouldn't be looking to, you know, kind of panic and fearful that, you know, there's a lot more downside that that is a risk. But, you know, you know, a mild growth scare would suggest the markets would have maybe a little more to fall from here. But ultimately, we think the fundamentals still suggest, you know, better growth ahead.
And that's a better environment for equities. And the last point I'd make on equities is that a key driver for U.S. equities in particular is the AI CapEx investment that could drive a big part of the S&P earnings. That's going to be less sensitive to what's happening in the Middle East.
So the upside there for earnings still looks attractive. And based off the completion of the Q1 earnings season, we still feel quite confident that earnings outlook this year will sort of materialize in a much more tail risk scenario with oil prices spiking all the way to $150 a barrel. Well, Jason, a very helpful conversation as we begin another trading week.
Thank you for dropping by to share with our listeners, our clients, your assessment of the current geopolitical environment, the economic environment, how it's all translating to the markets, perhaps influencing monetary policy, and how to position portfolios accordingly. So thanks again for dropping by, Jason, and have a great week ahead. You too.
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