The war in Iran: Four scenarios

The Iran war has escalated even further in recent days, but its outcome still mainly depends on its duration, intensity and expansion into the region. Communications from Washington clearly defined the ultimate goal, with President Trump expressly stating that his objective was “unconditional surrender”. Meanwhile, Iran appointed Khamenei’s son as the new Ayatollah. Considered a hardliner, he is not someone to readily yield to US-Israeli pressure.

At the same time, pressure is mounting not to let the conflict drag on for too long as higher energy prices and economic data are starting to weigh on US sentiment. The combination of rising oil prices (currently around 116 dollars per Brent barrel) and a cooling labour market does not present a rosy outlook, looking ahead to the November mid-term elections.

Diplomacy could offer a way out of the conflict, but it is uncertain whether this is feasible. Attempts at mediation and talks with regional players are in any event something to look out for. In that context, the Iranian President struck a conciliatory tone when addressing the Gulf states last Saturday, but his words fell on stony ground. KBC Asset Management applies four scenarios.

Military action remains limited in time, with the number of targets also being kept within bounds. The Strait of Hormuz reopens relatively quickly and physical oil transport is resumed. Oil may peak briefly but drops when shipping and insurance return to normal. We consider this scenario less likely today than we did early last week.

What signs do we look out for? Clear signs of de-escalation, a fully open Strait of Hormuz, tanker traffic returning to normal within days, stabilising insurance premiums, and oil prices that are not persistently above ~90 dollars.
Investment response: no major changes, retention of the strategic allocation and tactical rebuilding of the equity position.

The conflict lasts a few (4-5) weeks. The US declares ‘goal achieved’ after weakening Iranian capabilities; Israel ends its military action after US support is terminated. The regime remains in place; proxy activity (e.g., Hezbollah in Lebanon) will peter out. The oil risk premium drops, but the Strait of Hormuz remains a lurking threat.

What signs do we look out for? Statements like ‘objectives achieved’, a ceasefire or talks, reduced proxy activity, stabilisation of the Hormuz threat. 

Investment response: largely retain positions, no overreacting but anticipating higher oil prices and, as a result, higher inflation. Central banks cannot provide relief. In this scenario, the risk-off sentiment may linger for some time. European shares are more vulnerable than US shares.

The conflict continues but loses momentum. There is no official ceasefire, but the US considers the goals to have been achieved although Iran does not budge. This could result in a slower and more expensive functioning of the system, even if the situation improves. Prolonged uncertainty may arise, but without panic in the markets.

What signs do we look out for? More shipping activity without full normalisation, permanently higher costs/prices, unclear policy signals.
Investment response: the markets recover erratically; no panic, but no immediate ‘full return to normal’ either.

The conflict spreads through several parties (proxies, Hezbollah, Houthis), ongoing attacks on US assets, and permanent disruption in the Strait of Hormuz. The conflict lasts longer and also affects the regional energy infrastructure.

What signs do we look out for? Activation of several proxy fronts, ongoing attacks on bases/embassies, credible attempts to disrupt the Strait of Hormuz in the long term, visible damage to the Gulf infrastructure. No real prospect of de-escalation; the conflict proves to have been consistently underestimated; Iran adopts a ‘long war’ stance and uses proxies and the Strait of Hormuz as long-term leverage. The US provides Kurdish militants with arms. The Hormuz risk is priced in permanently. A blockade of the Strait of Hormuz that lasts for weeks could push up oil prices to well above 120 dollars, as this will cause demand destruction.

Investment response: a more defensive composition of the portfolios for a longer period of time. As regards the economic scenario, the risk of ‘stagflation’ – entailing weak or negative growth and high(er) inflation – is becoming more realistic.

To be continued…