Markets caught between de-escalation hopes and rising uncertainty

Markets are once again grappling with a rapidly shifting narrative in the Middle East, as the past 48 hours have delivered both optimism and renewed concern.

 
Late last week, sentiment improved sharply on signs that Iran could reopen the Strait of Hormuz and that a deal was within reach. That triggered a relief rally across equities and a sharp drop in oil. However, the breakdown in talks over the weekend and the re-imposition of restrictions on the Strait — alongside US action to intercept Iranian shipments — has quickly reversed that narrative.

The result is a market that feels stuck at a crossroads. Oil initially jumped higher on renewed supply fears but has since struggled to extend gains, reflecting uncertainty rather than conviction. Equities, meanwhile, are softer but far from panicked, suggesting investors are not yet fully pricing a worst-case scenario. This disconnect highlights a broader theme: markets are aware of the risks, but are still leaning toward the belief that escalation will ultimately be avoided. That view is underpinned by a key assumption — that both the US and Iran have incentives to reach some form of agreement. From the US perspective, the economic and political costs of a prolonged conflict are rising, particularly ahead of the midterm elections. For Iran, the damage to its economy and infrastructure is already significant. However, this assumption may be overly simplistic. Internal divisions within Iran, particularly between more moderate and hardline factions, could complicate negotiations and prolong the conflict beyond what markets currently expect.

At the same time, equity markets are being supported by factors beyond geopolitics. Earnings season has begun on a relatively solid footing, with expectations for double-digit growth still intact. This has provided a fundamental anchor for stocks, helping to offset some of the uncertainty coming from the Middle East. However, the real test is still to come. As more companies report and provide forward guidance, investors will gain a clearer picture of how rising energy costs and tighter financial conditions are affecting margins. That is where the current optimism may be challenged. Energy prices remain elevated, and while companies may have hedged some of these costs, sustained pressure could begin to show up in earnings and guidance. Sectors such as airlines, industrials and manufacturing will be particularly important to watch. If companies begin to signal margin compression or weaker demand, it could force a reassessment of the market’s current positioning.

For now, markets are operating in a state of conditional optimism. Investors are effectively betting that the conflict will de-escalate, even if the path there is volatile. But this leaves markets vulnerable. If negotiations continue to falter or if escalation resumes, the current balance could shift quickly, leading to renewed volatility across asset classes. In essence, the story remains the same: markets are trading the probability of outcomes rather than the outcomes themselves. And right now, that probability still favours resolution — but not by enough to remove the risk of sharp reversals.