How Wall Street is weighing recession risks amid the Israel-Iran conflict

Markets are not pricing panic, but sovereign allocators are reading the signal differently.

The latest US airstrikes on Iranian nuclear facilities—and the subsequent spike in odds of Iran closing the Strait of Hormuz—have reignited concerns that inflation control and global growth may once again be held hostage by a 21-mile-wide maritime corridor. While oil prices have moved modestly—Brent at $76 and US crude at $73—the tail risk has widened considerably. And for capital allocators operating in a post-COVID, high-debt, low-reserve world, tail risk is the constraint that matters.

This isn’t merely about short-term price movements. It’s a test of system fragility—and a reminder that macro shocks still hinge on real-world chokepoints.

At first glance, markets appear calm. Equities are steady, the 10-year Treasury yield is flat, and even gold is holding ground. But a deeper look reveals structural unease. Over the weekend, Polymarket saw odds of Iran closing the Strait of Hormuz spike to over 50%. This is more than a speculative trade—it reflects institutional anxiety about geopolitical escalation. With nearly 20% of global oil flowing through this strait, any credible threat of closure introduces a non-linear inflation risk. It doesn’t take a full blockade—just credible disruption is enough to reroute capital.

Goldman Sachs has kept its US recession probability unchanged at 30%, citing this very risk. Jan Hatzius, its chief economist, warned that while current oil levels are not yet a macro threat, a “tail scenario” involving closure or escalation could push Brent to $110 and send recession odds sharply higher.

In a worst-case model, Goldman predicts a 50% drop in oil volumes for one month, followed by an 11-month partial recovery. The result? Brent peaking at $110 before settling near $95 by Q4 2025. That alone could reduce global GDP growth by 0.3 percentage points and raise inflation by 0.7 points—enough to stall monetary easing across advanced economies.

The issue isn’t volatility—it’s asymmetry. Policymakers and fund allocators can hedge against moderate price fluctuations. But they can’t easily hedge systemic chokepoint exposure. The Strait of Hormuz represents a classic single-point macro failure: geographically narrow, logistically irreplaceable, and politically fraught.

Unlike financial contagions, energy shocks tied to physical infrastructure cannot be easily sterilized. They force real tradeoffs: central banks must choose between defending inflation anchors and protecting growth. And in a world where both fiscal and monetary buffers are thin, even a brief supply disruption can cascade into second-order effects—spiking transport costs, squeezing industrial margins, and amplifying food price shocks.

Goldman’s base case of Brent falling to $60 assumes a contained geopolitical arc. But the probability distribution is skewed—and sovereign allocators know it. Capital doesn’t just chase base cases. It guards against tail events.

For sovereign wealth funds in the GCC and Asia, this conflict cuts both ways. Higher oil prices improve fiscal receipts in the short term, but asset volatility undermines long-horizon planning. Funds like GIC, ADIA, and NBIM have rebalanced heavily toward infrastructure, logistics, and long-duration assets—many of which are sensitive to global energy and transport dynamics.

Even portfolios with limited direct oil exposure must now reassess correlated risk: energy-intensive manufacturing, global shipping, and emerging market sovereign debt all become vulnerable under a prolonged disruption. Meanwhile, insurance costs, hedging premiums, and commodity-linked credit spreads are already adjusting.

This is not about exiting risk. It’s about repositioning liquidity. Sovereign allocators don’t flee volatility—they shift toward resilience: infrastructure with contractual stability, inflation-linked debt, and assets buffered from energy pass-throughs.

Policymakers may recall the 1990 Gulf crisis when oil surged above $40 after Iraq’s invasion of Kuwait. Then, reserve buffers were thicker, fiscal flexibility higher, and monetary coordination more robust. Today, the picture is less forgiving. Public debt has ballooned post-pandemic. Fiscal space is politically constrained. And central banks are walking a narrow line between credibility and responsiveness.

Crucially, today's inflation is not purely supply-driven. Services inflation, wage stickiness, and de-globalization trends have already lifted the floor. An oil shock here is additive—pushing an already elevated inflation environment toward unanchored expectations. This is what sovereign allocators fear most: not inflation alone, but inflation that forces premature policy tightening in economies already facing growth fatigue.

While equity markets remain superficially calm, fixed income signals are less sanguine. Breakeven inflation spreads have widened. Real yields are rising. And forward rate expectations are shifting toward a “higher for longer” plateau. Morgan Stanley’s warning that a 75% year-over-year oil price spike could drive a 19% correction in the S&P 500 reflects historical precedence, not alarmism. In prior cycles, such shocks have disrupted business investment, weakened consumer sentiment, and forced abrupt policy pivots.

JPMorgan, meanwhile, assigns a 21% chance to a Persian Gulf disruption that could lift oil to $120–$130. Even if that’s not the base case, it’s within allocation scenarios. Martijn Rats, Morgan Stanley’s commodities strategist, puts it plainly: only prolonged disruption justifies such spikes—but in the Strait of Hormuz, disruption doesn’t need to be long. It just needs to be credible.

Central banks are not powerless—but they are constrained. A conflict-driven energy shock is not a demand problem. Raising interest rates won’t restore shipping flows or secure pipelines. But failing to respond to inflationary pressure risks unanchoring expectations and undermining currency stability. This is the dilemma facing the Federal Reserve, ECB, and Bank of England. Do they preempt a second inflation wave—and risk stalling fragile growth—or do they wait and absorb the reputational cost?

For regional central banks—like MAS, SAMA, and HKMA—the question is different. They must consider imported inflation, FX volatility, and global risk aversion toward EM assets. Energy exposure is not just a commodity issue. It’s a balance-of-payments risk.

The Strait of Hormuz risk may or may not materialize. But it has already reshaped macro assumptions. In the near term, we can expect the following capital allocation behaviors:

1. Shift toward real assets: Infrastructure, logistics, and inflation-protected bonds will gain allocation share.
2. Repricing of oil-sensitive regions: Frontier and EM markets exposed to oil imports may see funding pressure.
3. Defensive positioning in FX: Currencies tied to oil flows or trade imbalances will come under scrutiny.
4. Liquidity over yield: Funds will prioritize reallocatability over risk premia.

This is not about fear. It’s about optionality. When the corridor through which 20% of the world’s oil flows becomes uncertain, prudent capital doesn’t wait. It hedges first—and reallocates later.

This is not a 1970s-style oil crisis. But it is a 2020s-style capital inflection point—where geopolitical chokepoints constrain monetary autonomy, and tail risks reshape global portfolio logic.