Markets in the fog …

Amid mounting global uncertainty, financial markets remain surprisingly resilient.

Despite war between Israel and Iran, rising trade tensions under US President Donald Trump, and volatile monetary policy expectations, the S&P 500 continues to hover near record highs.

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Is this irrational optimism, or a rational response to temporary noise? Geopolitical shocks are nothing new.

Historical data shows that, on average, the S&P 500 drops by around 6% in the three weeks following a major geopolitical incident but often rebounds within another three weeks.

From World War II to the invasion of Ukraine in 2022, the pattern remains – investors initially retreat, then reassess.

The current Middle Eastern conflict has yet to break this pattern.

This muted reaction may reflect structural shifts. In 2020, the US became a net petroleum exporter for the first time since 1949. Oil remains a crucial commodity but its influence on inflation and economic output has diminished, especially in developed markets with diversified energy sources. Iran’s contribution to global oil supply, for example, is less than 2%, limiting the long-term impact of disruptions.

Markets pricing in probability

Yet markets are not ignoring the risks. A significant and prolonged shock, particularly one that shuts the Strait of Hormuz, could push oil above $120 a barrel. This would likely reignite inflation and force central banks to revise rate-cut plans.

Until then, however, markets are pricing in probability, not panic.

Read: What’s so special about the Strait of Hormuz?

That brings us to the US Federal Reserve (Fed). Policymakers are split. Some argue for rate cuts to stimulate growth, especially given softening inflation and weakening consumer demand. Others warn that Trump’s new tariffs may drive prices higher.

The Fed’s recent meetings highlight this divide, with officials projecting anything from two rate cuts to none at all (we think two rate cuts would be in order).

Read:
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Adding to the complexity is Trump’s erratic influence. His public attacks on Fed Chair Jerome Powell and suggestions that he might “appoint himself” to the central bank have unsettled markets.

And while some tariffs may temporarily boost domestic manufacturing, the ripple effects on consumer prices, global supply chains, and business sentiment could be negative. The World Trade Organisation and numerous analysts have warned that retaliatory measures could spiral into another global trade war.

‘Currency trilemma’ and vulnerabilities 

Beyond the US, China is also navigating treacherous waters.

Its currency dilemma is representative of a broader global imbalance. The renminbi is currently undervalued, yet China fears that a stronger currency would entrench deflation and hinder exports. At the same time, a weaker renminbi could destabilise Asian currencies and invite political backlash from trade partners.

This ‘currency trilemma’ – appreciation, depreciation, or stability – reflects China’s internal policy contradictions.

A stronger renminbi could help the country move up the value chain and support the internationalisation of its currency, particularly as global trust in the US dollar weakens. However, doing so would require bold reforms, including efforts to increase consumption, reduce savings, and allocate capital more productively. Beijing’s choice will affect not only China’s economy but also global trade flows and capital markets.

Europe, meanwhile, faces its own moment of reckoning.

Trump’s second-term policies have highlighted the European Union’s vulnerabilities – its reliance on US military support, digital infrastructure, and even energy policies. Leaders are pushing for deeper integration, particularly in capital markets, and a stronger role for the euro.

A true European safe asset and a single regulatory framework could make the euro more competitive as a reserve currency, diversifying global capital flows.

Assessment then?

In the above context, investors are not irrationally calm.

They are selectively weighing risks, adjusting portfolios, and watching the July deadline for Trump’s paused tariffs.

For now, the outlook remains uncertain. Markets, as ever, are forward-looking but the fog of war, tariffs, and currency distortions make that view more cloudy than usual.

Dr Francois Stofberg is a financial well-being economist at the Efficient Group.

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