“Boy, that escalated quickly!” While we don’t want to trivialize the war in the Middle East or the market sell‑off since February, this memorable line uttered by Will Ferrell in “Anchorman” is one cheeky way to describe the about‑face in market returns and risk appetite relative to January’s optimistic outlook. It’s also a reminder that quick turns in expectations can amplify moves as investors scramble to cover wrong‑footed positions in equities and bonds.

While technical factors have certainly played a role in the dramatic moves to date, we think the conflict warrants a reset of expectations for risk and returns this year. The reason: With some energy infrastructure already damaged and the potential for more, energy supply-chain disruptions and elevated oil and gas prices could persist for months, even if the Strait of Hormuz reopens fully during the ceasefire. Of course, it’s worth emphasizing that the situation remains fluid and subject to change in the coming days and weeks.

The macro backdrop is stagflationary, with potential implications across asset classes. Higher energy prices are feeding into headline inflation (including food, due to higher fertilizer prices), while also adding about one percentage point to core inflation as they spill over into transportation, chemicals, packaging, pharmaceuticals, and all things plastic. Depending on how long elevated oil prices persist, we also think growth expectations could be dented as consumers cut back. Companies’ decisions about whether to absorb higher input costs or pass them through to customers will be key for earnings expectations and, by extension, the labor market.

Despite these headwinds, we maintain our moderately overweight view on global equities over our 12‑month horizon for several reasons. The year began with strong earnings momentum, the AI innovation theme remains intact, valuations are more attractive, and fiscal policy remains supportive. In addition, elevated volatility and differences in sensitivity to energy prices have created regional opportunities within equities. Finally, in past stagflationary periods marked by oil price spikes of at least 20%, markets have posted decent returns within 12 months (FIGURE 1). We favor the US and EMs and hold a moderately underweight view on Europe ex‑UK and an underweight view on the UK.

We’ve maintained our long‑duration stance, supported by more attractive carry⁷ and two potential states of the world that could lead to lower yields. In one scenario, persistently high energy prices spill over into higher prices for a range of goods, leading to demand destruction and slower growth expectations. In the other, a de‑escalation in the conflict reduces inflation expectations and lessens the need for more hawkish central bank reaction functions.

When considering possible inflation outcomes, some have drawn comparisons between the current energy supply shock and the 2022 shock driven by the war in Ukraine. However, we see several important differences that could help contain inflation today. First, governments have less fiscal flexibility to provide stimulus than they did in 2022. Second, policy rates in some regions (US, UK) were already in mildly restrictive territory. Third, labor markets aren’t as tight as they were in 2022.

As noted, we maintain an underweight view on Japanese government bonds, given that inflation and fiscal risks are meaningful, but both central-bank reactions and inflation and real yields have moved less than in other regions.

As for credit, we remain focused on quality. Spreads⁸ widened modestly in March in response to conflict‑induced volatility and simmering concerns around private credit. Markets are also absorbing increased supply from AI‑driven hyperscaler issuance and merger and acquisition financing. To take advantage of wider spreads while remaining alert to potential spillover risks from the private-credit space, we favor European credit, including both investment‑grade and high‑yield bonds.

Credit fundamentals are healthier in Europe than in the US, particularly around debt service and leverage. The market is also more heavily weighted toward asset‑intensive sectors rather than software‑ and AI‑related leveraged borrowers. In addition, while US banks aren’t typically direct lenders to middle‑market borrowers, they do lend to private-credit funds and vehicles—a relationship that applies less to European banks.

Commodities: Rethinking Our Views on Oil and Gold

Prior to the war, we held a modest underweight view on oil. However, the onset of hostilities and the resulting surge in oil prices led to a considerable widening in the range of possible outcomes for the asset class, with risks skewed toward the higher end. This heightened uncertainty, combined with the exceedingly high costs associated with rolling positions at the front end of the curve, rendered the risk‑reward profile of our underweight view untenable, prompting a shift to a neutral view.

Meanwhile, we used the recent sell‑off in gold to introduce a slight overweight view. While some long positioning in gold has been cleared out since the war began, leaving it to behave more like a risk asset,⁹ we believe the fundamental case remains intact. That includes strong long‑term demand potential and gold’s role in diversifying away from the USD.

The biggest risk to our long‑term bullish thesis for gold is the possibility that central banks become net sellers to meet capital needs related to the war. This tempers our conviction and keeps us from moving to a larger overweight, despite the potential for meaningful excess returns relative to cash. Importantly, we would push back against the notion that gold is a reliable inflation hedge, as correlations have been weak or nonexistent. Instead, the primary long‑term relationships are negative correlations with the USD and real yields. While we don’t see significant upside developing in either, a renewed fundamental bull case for the dollar is an additional risk.