Keeping calm under fire: Key things to watch for as Israel-Iran conflict escalates

What we know so far

Israel's rapid strikes have dealt significant damage to Iran's command and control, military, and nuclear capabilities. However, reports are that Iran's most hardened nuclear facilities, including at Fordow and Natanz (which are buried 40m or more under the surface or within mountains), remain broadly intact. Israel has indicated that it intends to continue strikes on Iran, with a primary goal of permanently dismantling its ability to develop nuclear weapons and a secondary goal of fomenting regime change in the country.

Iran has retaliated with a barrage of ballistic missile and drone strikes, though it may soon encounter difficulties sustaining the intensity of the conflict given the damage Israel has inflicted on its capabilities. Meanwhile, the US has directly and clearly stated that it did not participate in any way in the Israeli operation, warned Iran against attacking US assets in the region, and continued to urge Iran to return to the nuclear negotiations that the Trump Administration continues to believe is the best way to move forward.

Key signposts to watch

We are clearly in a very fluid and tactically active environment, and deep within the ‘fog of war'. There are significant uncertainties and developments that may substantially change the situation for the better or for the worse. In the immediate-term, investors will be watching for signs of:

1. further escalation, whether through:
   1. Israeli strikes on more Iranian energy infrastructure, including the Kharg Island Terminal, which handles 90% of Iran's oil exports
   2. An Iranian attempt to disrupt the Strait of Hormuz
   3. Iranian strikes on US assets in the region
2. either Israel or Iran exhausting their ability to sustain the conflict (modern warfare consumes tremendous amounts of material!), allowing a stabilisation
3. the US and other powers pushing to achieve a de-escalation
4. domestic political pressures on either Israel or Iran to de-escalate.

Constraints may force a ‘peak' in hostilities; Trump and Netanyahu's actions will be key

As outlined in our February 2025 Observations piece The New Great Game, we apply a constraints-based framework to assess political and geo-political developments. Developed by Marko Papic of BCA Research, this approach focuses on understanding the material constraints facing policymakers to determine the most likely or plausible courses of action, rather than relying on their stated preferences or fearful newspaper headlines. Of course, the key caveat here is that we are operating off our best assessments of publicly available information, and policymakers may choose not to pursue the most likely course of action.

People make mistakes! However, when a policymaker goes against their material constraints, as US President Trump did on ‘Liberation Day', they learn about it very quickly.

Applying this framework to today's situation suggests that, while each of Israel, Iran, and the US have their own preferences or objectives, the constraints facing them indicate that the most likely course of action is a stabilisation in the conflict:

Israel / Netanyahu

• Israel likely seeks a permanent dismantling of Iranian nuclear capabilities and potentially regime change, as well as keeping Prime Minister Netanyahu's right-wing coalition intact
• However, it currently lacks the capability to do further significant damage to the most hardened Iranian nuclear facilities without direct US support. It is also rapidly expending its most effective munitions, which will need to be replenished (by the US).

Iran

• Iran likely seeks some face-saving retribution on Israel, and to retain some nuclear capabilities as leverage in eventual negotiations with the US
• However, it has suffered substantial damage to its command and control and power projection capabilities, while severe damage to its nuclear programme reduces its leverage in negotiations. Iran is also likely close to running out of effective munitions, and in any case its military cannot hope to survive conflict with the US. In 1988, an Iranian attempt to close the Strait of Hormuz ended with the US navy destroying almost the entire Iranian navy within a single day (see Operation Praying Mantis).

US / Trump

• The US and Trump likely see a nuclear deal with Iran as the most practical way to achieve lasting de-escalation and ‘peace' in the Middle East. In addition, Trump has declared an aversion to regime change in Iran, as well as a reluctance to involve the US in another military conflict in the Middle East
• The constraints facing the US in this instance are likely not binding. It wields overwhelming military supremacy and has the capacity to act swiftly and decisively if it chooses (or is compelled) to do so. That said, the US populace has little appetite for yet another Middle East war, and a sustained oil price spike would significantly damage the US economy and Trump's popular support.

We believe the pivotal, or ‘fulcrum' actors in this case are US President Trump and Israeli PM

Netanyahu. Effectively, the US and Trump hold the key to escalating or de-escalating this conflict, by with- holding support for further Israeli actions or by getting involved directly. Netanyahu can either take the win or seek to goad the US by escalating matters. We see the most likely outcome being that the constraints on all parties eventually force a stabilisation or de-escalation in the conflict that allows for a resumption of US-Iran nuclear negotiations. That said, our scenario analysis indicates that downside risks have clearly risen.

An assessment of plausible scenarios indicates a low but significant tail risk of escalation

The constraints-based analysis above informs our assessment of the most plausible forward scenarios, noting the wide band of assessed likelihoods reflects the extraordinary levels of uncertainty we are dealing with:

1. (60–80%) Conflict stabilises.
   1. Our central case outcome is that Israel accepts the substantial ‘win' it has already achieved in degrading Iran's capabilities, and allows the US and Trump to re-take the lead in negotiating with a now-weakened Iran. In this scenario, markets will likely ‘move on' from the conflict and re-engage with the prevailing macro risks and uncertainties.
2. (20–40%) Conflict escalates.
   1. Iranian energy infrastructure, the Strait of Hormuz, and/or US assets serve as a flashpoint for further escalation of the conflict that draws in the US and risks global oil supplies
   2. There is also an extreme tail scenario of regime change in Iran. The implications of this are currently unknown and could present extreme two-way risk to the outlook.

What does this mean for economies and markets?

To the casual observer, such an elevated probability of conflict escalation might call for emergency de-risking of portfolios. However, we think that might be the wrong call to make for a few reasons:

1. Our central case still involves a stabilisation in the conflict, and history tells us that geo-political shocks rarely cause sustained market drawdowns. In fact, across 28 geo-political events since 1956, BCA Research found that after initial drawdowns, markets were on average 9% higher 12 months on. Simply put, markets are heartless creatures that move on quickly
2. If the conflict were to escalate, we assess a very high probability (80% – 90%) that policymakers will step in to backstop the economy and markets. Trump can release oil from the Strategic Petroleum Reserve to support oil supplies, while the expected spike in oil prices (potentially to US$130/barrel according to JP Morgan) will encourage increased production from US and other producers. Meanwhile, we can expect the Federal Reserve to similarly do its part, likely via emergency liquidity support for markets, and potential emergency Fed rate cuts. The current broadly disinflationary backdrop further supports this. In other words, after an initial (potentially sharp) drawdown, policymaker support is likely to support a market recovery.

Investment Implications

In the immediate term of the next few weeks, we expect elevated market volatility until we get a clearer signal that the ‘peak' of this conflict is in and greater clarity on the outlook. This might mean:

• Gold and oil are likely to remain bid on higher geo-political risk premia, though we would be careful of chasing this. Prices have risen substantially already and, as we have experienced in past Middle East conflicts, geo-political risk premia can fade very quickly once uncertainty peaks.
• Safe haven currencies (CHF, JPY, and to an extent the USD) are likely to benefit from investor caution. The US dollar would typically be expected to strengthen here (and the AUD weaken), but prevailing macro uncertainties around US trade, US fiscal policy, and US domestic politics are likely to drag it down relative to more traditional safe havens like the yen.
• The outlook for bond yields is uncertain, with downward pressure from safe haven flows potentially offset by higher oil prices (and its impact on pushing inflation higher).
• Equities, after retracing all of their ‘Liberation Day' losses and with valuations back to historically elevated levels, equities appear vulnerable in the near-term.

So, what actions should prudent investors take in the wake of this conflict?

As with any bout of market volatility, the first and most important rule of investing is Don't Panic. As we saw during the ‘Liberation Day' volatility in April, markets can and do react violently in both directions to unexpected shocks. We believe that attempting to trade this conflict on a daily basis could prove to be both extremely difficult and expose portfolios to lost future gains.

We continue to advocate that investors assess these events through a disciplined and objective framework, like the one we laid out above, and think prudently about the most appropriate actions to take in line with their long-term investment objectives.

We remain comfortable with our current Tactical Asset Allocation (TAA) tilts and portfolio positioning:

• 2025 was always going to be a volatile year. Political and geo-political uncertainty, higher volatility, and higher dispersion are key components of our tactical outlook for 2025. We choose to navigate through this volatility with a focus on identifying the opportunities that may emerge.
• Diversification is one of the few free lunches in markets. The bouts of volatility this year are a good reminder of this. We continue to emphasise maintaining robust portfolios that are diversified across asset classes and funds, and not overly exposed to any one style or theme to deliver a positive outcome. While a positive correlation between equities and bonds has presented some portfolio construction challenges in recent years, fixed income should underpin portfolios should a risk-off environment. In addition to fixed income, defensive alternatives also provide an additional lever and versatility for portfolios in this environment. We continue to focus on quality and active management, attributes we feel are prudent in higher volatility and higher dispersion markets.
• Our central case is that the conflict stabilises without a sustained impact on global oil supplies, and markets re-engage with the prevailing macro and market risks and opportunities, including:
  • US fiscal policy and the One Big Beautiful Bill Act
  • US trade negotiations
  • Inflation and the Federal Reserve
  • US macro, recession, and earnings risks
• Our cautiously optimistic +1 overweight to equities is well positioned for our central case, which is that a peak in US trade uncertainty and continued progress on inflation allows central banks to cut rates to support a modestly slowing global economy.
• We retain a slight overweight to global government bonds as a downside risk hedge.
• We retain plenty of dry powder to respond to evolving risks and opportunities. Our bias remains to buy on geo-politically induced market weakness.