Market IQ | Political and capital market insights

The macro backdrop remains dominated by the U.S.–Israel conflict with Iran and the associated Iran–Hormuz shock, which has re-priced geopolitical risk premia through energy markets and global shipping channels. With roughly 20 million barrels per day of petroleum liquids transiting the Strait of Hormuz in 2024 (about 20% of global consumption), even intermittent disruption risk is enough to keep an elevated oil risk premium in place and increase uncertainty around inflation and real incomes.

In the United States, the first-order macro impulse is being treated as a supply shock rather than a trigger for renewed tightening: higher gasoline and freight costs squeeze real income, soften consumption at the margin, and raise downside growth risks even as headline inflation volatility increases. The Federal Reserve remains data-dependent and increasingly sensitive to the risk that tighter financial conditions arrive via risk premia (not policy), which supports a bias toward patience while policymakers assess whether energy-driven price pressures spill over into broader inflation expectations.

Outside the U.S., the growth and inflation trade-off is more challenging. Europe remains more fragile given its higher sensitivity to energy price persistence and weaker cyclical momentum, while Japan, Korea, and parts of EM Asia are particularly exposed to energy-import and trade channels if Strait disruptions linger. By contrast, parts of Latin America are relatively better positioned given commodity exposure and improved fundamentals, reinforcing a higher-dispersion environment across emerging markets.

Across regions, energy remains the primary transmission channel for macro risk, and the distribution of outcomes is highly path-dependent. A renewed escalation (including strikes on energy or civilian infrastructure, or further impairment of Hormuz transit) would raise stagflation risk, tighten financial conditions, and likely be expressed through wider credit spreads and more defensive factor leadership, with higher-quality duration exposures benefiting on a relative basis. A credible turn toward de-escalation, even without a full resolution, would likely compress risk premia and support risk assets and credit, particularly in the regions and sectors most penalized by energy and shipping uncertainty.

Markets lost momentum during the quarter, with weakness concentrated in U.S. large-cap growth and broad softness across global fixed income. The MSCI ACWI Index returned -3.2%. In the U.S., the S&P 500 returned -4.33% and the Nasdaq 100 Index returned -5.82%, while the Russell 2000 gained 0.89%. Internationally, MSCI Europe returned -2.82%, MSCI Japan gained 1.37%, and MSCI EM was nearly flat at -0.17%. Fixed income was mixed and modestly negative: the Bloomberg US Treasury Index was essentially flat at -0.04%, while the Bloomberg US Corporate Bond Index returned -0.54%, Bloomberg US High Yield returned -0.50%, Bloomberg Global Aggregate returned -1.07%, and Bloomberg EM Hard Currency returned -1.61%. Overall, Treasuries were relatively resilient, while Japan and U.S. small caps were relative standouts within a softer global risk backdrop.

We enter the quarter with a modestly defensive overall asset allocation, reflecting elevated geopolitical risk, uneven global growth dynamics, and a still-restrictive real-rate backdrop. At the total portfolio level, we are 0.5% underweight equities, 2% underweight fixed income, and 1% overweight alternatives.

Within equities, we maintain a selective and regionally differentiated stance. We remain underweight U.S. small-cap equities, where tighter financial conditions, higher refinancing risk, and sensitivity to domestic growth slowdowns continue to pressure earnings durability. We are neutral U.S. large caps, supported by balance-sheet strength and relatively stable earnings profiles, but constrained by valuation and policy uncertainty. We have reduced our overweight to emerging markets equities to 0.5%, reflecting a more cautious near-term risk posture amid elevated energy prices and shipping disruption risk, which disproportionately affect EM Asia and other energy-importing economies. We retain a modest overweight given the asset class’s upside potential in a de-escalation scenario and the index’s growing exposure to higher-quality, tech-oriented earnings streams, while acknowledging that dispersion within EM remains high (with Latin America relatively better positioned than parts of Asia). We remain neutral in Europe, Japan, and APAC ex-Japan, where valuation support is offset by cyclical exposure and sensitivity to energy and global trade disruptions.

Within fixed income, we continue to position the asset class as the portfolio’s primary shock absorber in an environment where geopolitical developments are a key driver of growth and inflation outcomes. We are 3% underweight U.S. Treasuries, reflecting ongoing supply pressure and uncertainty around term premia, while maintaining a modest long duration bias through +1.0 year exposure in the 1Y to 2Y sector and +0.25 years in the 7Y to 10Y sector to help offset risk-asset drawdowns in an escalation scenario. We remain overweight U.S. investment-grade credit, where all-in yields and balance-sheet quality provide defensive income. We also hold a modest overweight to U.S. high yield, where wider spreads have improved relative value, but we remain selective given late-cycle fundamentals and the risk that a prolonged energy shock, amplified by disruptions to shipping through the Strait of Hormuz, could tighten financial conditions and pressure lower-quality borrowers.

Within alternatives, we are overweight real assets, led by a 1.5% overweight to global natural resources equities and a 1% overweight to infrastructure. We view these exposures as a practical hedge against supply-driven inflation risk and second-round price effects that can arise when Middle East tensions disrupt energy and shipping flows, particularly if restrictions through the Strait of Hormuz persist and keep oil and refined-product markets tight. We remain 1% underweight U.S. REITs, where fundamentals are improving but performance remains sensitive to the level and volatility of long-end yields. We are neutral commodities as a diversified return and hedge sleeve: in a prolonged Iran-related conflict scenario, energy, select industrial metals, and other strategically important inputs can benefit from risk premia, supply uncertainty, and higher security-related capex, while the position also provides portfolio convexity if the inflation impulse proves more persistent than expected.