Conflict has broken out in the Middle East, introducing a new layer of uncertainty for the economy and markets. The situation remains fluid. We outline below some of the potential implications of the Iran conflict and other geopolitical developments for Canada, the U.S. and the broader global economy.
The Fog of Geopolitics
On February 28th, the U.S. launched a large-scale military offensive against Iran following weeks of military buildup in the region. The escalation materially increased geopolitical risk and injected renewed volatility into financial markets. Equity markets retreated and bond yields edged higher in response to a sharp rise in oil and natural gas prices, reflecting worries of supply disruptions tied to a potential prolonged closure of the Strait of Hormuz.
History can provide valuable perspective. While geopolitical shocks often generate short-term market turbulence which is occasionally severe, these shocks have historically had limited influence on longer-term market direction. Across roughly two dozen significant military conflicts since 1950, the S&P 500 delivered positive returns twelve months later nearly three-quarters of the time. Markets typically adapt as uncertainty gradually gives way to clearer policy direction and improved economic visibility, making the episodes more transitional than structural.
Nevertheless, military conflicts are inherently unpredictable. As such, the balance of risks surrounding the economic outlook has worsened at the margin. In our view, oil prices remain the key factor to monitor. The $100-per-barrel level represents an important psychological and economic threshold, as sustained increases could adversely influence consumer spending and inflation. We expect financial markets to remain sensitive to energy prices in the near term, and a durable decline in the price of oil would help build confidence that tensions are receding. Market volatility could then begin to normalize.
Despite heightened uncertainty, macro conditions remain reasonably constructive. The world economy was on a sturdy foundation prior to the conflict, underscored by broadening growth momentum and strong corporate earnings trends. This suggests to us that businesses and markets entered this period of geopolitical tension from a position of relative resilience.
Global and U.S. Implications
Energy markets have been exceptionally volatile, with oil prices moving within a wide range as investors attempt to gauge the likely duration and intensity of the conflict. Ultimately, how high oil prices rise, and how long they remain elevated, will be the key determinants of the broader economic impact. The impact will vary significantly across regions, particularly between energy-importing and energy-exporting economies. Europe and much of Asia remain heavily reliant on imported energy, leaving them more vulnerable to higher inflation and weaker growth if oil prices stay high.
The U.S. is somewhat better positioned to absorb an energy shock. The amount of oil required to produce one unit of GDP is about 70% lower than in the 1980s, and the country’s position as a net energy exporter reduces its direct exposure to supply disruptions. Reflecting these dynamics, U.S. equity prices, while lower since hostilities began, have generally held up better than many international peers, while the U.S. dollar has strengthened against most major currencies. A prolonged period of elevated oil prices would, however, still represent a headwind for the American economy by placing pressure on discretionary consumer spending and raising input costs for businesses. The combination of increased inflationary pressures and slower growth could complicate the U.S. Federal Reserve’s policy outlook, with markets recently paring back expectations for near-term rate cuts.
Implications for Canada
Canadian equity prices have also declined since the conflict began, though the S&P/TSX Composite Index remains in positive territory year-to-date. The Canadian market’s significant weighting in the Energy sector has provided support, helping to offset weakness in other sectors. Energy accounts for roughly 15% of Canada’s goods exports and approximately 6% of GDP, suggesting that Canada could see some modest economic benefit from higher oil prices.
Canada’s ability to fully capitalize on rising prices is constrained by limited pipeline capacity, which limits how quickly exports can increase. As in other countries, higher oil prices have mixed economic effects: stronger revenues for energy producers and governments, but higher fuel costs for households and businesses. For interest rates, the potential for renewed inflationary pressure tied to the conflict has added uncertainty to the outlook for the Bank of Canada’s benchmark rate, with futures markets now pricing in some probability of monetary policy tightening in the second half of the year.
Takeaway
Markets dislike uncertainty. Renewed Middle East conflict has produced the expected reaction: uncomfortable volatility stirred by sharply higher energy prices. The key unknown, which markets are struggling most to assess, is the ultimate length of restriction of traffic in the Strait of Hormuz. Inconsistent messaging from the U.S. administration around the duration of its remaining operations has added to the uncertainty, limiting visibility for investors.
The economic outlook is less certain than it was two weeks ago. We are closely monitoring for signs that financial or economic stress may be emerging. With a wider range of possible outcomes now in play, maintaining discipline becomes particularly important.
While markets may remain unsettled in the short term, longer-term outcomes ultimately reflect fundamentals such as economic growth and the long-term trajectory of corporate earnings. In our view, recent events continue to highlight the value of diversification and remaining aligned with long-term investment goals as a prudent approach to navigating inevitable periods of uncertainty.
If you have any questions, please do not hesitate to contact us.
Drew M. Pallett LL.B.
Senior Portfolio Manager and Investment Advisor
RBC Dominion Securities
Email: drew.pallett@rbc.com