Markets, the Fed and the Economy Are Underpricing War Risk, Says One Strategist
Investors have learned to look through conflict. After a decade in which every geopolitical scare seemed to fade into the background, asset prices today embed strikingly little compensation for the possibility that wars broaden, supply chains break again, and inflation proves stickier than central banks hope. That complacency, a veteran macro strategist argues, now sits at odds with the world as it is—not as markets wish it to be.
Why markets keep discounting conflict
Several forces explain why risk premia have stayed thin despite persistent flashpoints:
– The “buy the invasion” pattern. In recent years, initial selloffs around kinetic events have often been followed by fast rebounds as worst-case scenarios didn’t materialize and policy support arrived. That behavioral muscle memory encourages investors to fade shocks rather than price sustained damage.
– Abundant liquidity and systematic flows. Passive inflows, buybacks, volatility-targeting strategies and carry trades suppress volatility and tighten financial conditions, muting the market’s signal function on tail risks.
– Energy resilience narratives. The shale revolution, high inventories at times, and spare capacity in OPEC have fostered a belief that oil spikes will be brief and containable, even when tanker routes are threatened.
– The central bank “put.” Years of crisis-fighting have conditioned markets to assume policymakers will smooth shocks. But as the strategist notes, a commodity-led inflation shock is precisely the kind that constrains monetary policy, not empowers it.
The channels from war to prices and growth
History shows conflict transmits to markets and the real economy through identifiable pathways. Several are already flashing yellow:
– Commodities and logistics. Escalation in the Middle East or the South China Sea could push crude, refined products, and key industrial inputs higher. Insurance premia on shipping lanes can jump, rerouting traffic and lifting freight rates. Even short-lived disruptions can propagate through just-in-time inventories.
– Financial plumbing and sanctions. Weaponized finance—sanctions, export controls, asset freezes—can fragment capital flows, widen cross-border basis spreads, and raise the cost of dollar funding for non-U.S. institutions.
– Cyber and infrastructure risk. Attacks on pipelines, grids, ports, or data centers raise tail risks for corporates and municipalities. These are low-probability, high-impact events that are difficult to hedge after the fact.
– Fiscal rearmament. Defense outlays, industrial policy and inventory rebuilding boost nominal demand and crowd out other spending over time. That mix tends to lift term premia and can entrench a higher equilibrium for interest rates.
– Corporate behavior. Boards prioritize resilience over efficiency: more capex for redundancy, higher working capital, and diversified suppliers. Margins can compress in the transition, even if long-run robustness improves.
What the Fed can and cannot insure against
The strategist’s core contention is not that the Federal Reserve is unaware of geopolitics, but that its mandate and tools limit its ability to preempt war-induced stagflation.
– Reaction function. If conflict hits demand harder than prices, the Fed can cushion the blow with easier policy, liquidity facilities, swap lines, and balance sheet operations. But if the primary impulse is higher energy and goods prices amid tight labor markets, cutting rates risks rekindling inflation. That asymmetry means the “Fed put” is weaker for war shocks than for financial accidents.
– Financial conditions feedback. Low volatility, tight credit spreads and buoyant equities have loosened financial conditions, effectively offsetting some of the Fed’s restrictive stance. By ignoring war risk, markets keep conditions easy, which in turn pressures the Fed to stay higher for longer to ensure inflation returns to target—until a shock forces a sharper adjustment.
– Structural backdrop. Larger fiscal deficits, deglobalization, and rearmament point to a higher term premium over time. If so, both the neutral rate and the volatility of rates may be understated in current pricing, leaving duration exposed if a conflict accelerates these trends.
Lessons from history, updated for today
Past wars are imperfect guides, but they rhyme:
– The Yom Kippur War and the Iran-Iraq conflict delivered oil shocks that fed broad inflation.
– The first Gulf War produced a sharp but brief spike; ample spare capacity and swift resolution capped the damage.
– The Korean War saw a powerful inflationary burst tied to defense mobilization.
Today’s mix—tighter global energy capacity, concentrated supply chains in semiconductors and critical minerals, and widespread use of sanctions—suggests a higher probability of step-changes rather than smooth adjustments. That argues for a non-zero, possibly rising, geopolitical risk premium across assets, even if base cases remain benign.
What to watch
If markets are underpricing conflict, leading indicators should help separate noise from regime change. The strategist highlights:
– Energy term structures and crack spreads: sustained backwardation and widening refining margins signal tightness beyond headlines.
– Shipping and insurance: war risk premia in key lanes, rerouting through longer paths, and container and bulk rates.
– High-frequency vol: short-dated equity vol (VIX9D), rates vol (MOVE), and skew; persistent elevation suggests demand for protection beyond event windows.
– Cross-currency and funding: cross-currency basis in yen and euro, GCC and EM sovereign CDS, and bank funding spreads.
– Defense and critical infrastructure equities: persistent outperformance relative to the market can confirm a secular repricing of risk.
– Policy responses: movements in SPR releases, OPEC+ guidance, export controls, and indications of industrial mobilization.
Implications for portfolios and planning
Underpriced war risk does not require abandoning risk assets, but it argues for resilience:
– Build real-asset ballast. Exposure to energy producers, pipelines, and select commodities can offset spikes in input costs. Gold can hedge extreme geopolitical stress when real yields fall or policy credibility is questioned.
– Own some optionality. Long volatility, convex hedges on energy or shipping, and downside skew can be relatively inexpensive when complacency reigns.
– Diversify supply chains and revenue. For corporates, supplier mapping, dual-sourcing, and inventory buffers reduce single-point failure risk. For investors, avoid concentrated geopolitical exposures embedded in otherwise diversified indices.
– Watch liquidity, not just valuation. In war shocks, bid-ask spreads and market depth evaporate first. Ensure access to cash and short-duration instruments, and stress-test redemption windows.
– Avoid false comfort from averages. War risk is lumpy and path-dependent; it may not show up in annual return means but in fat tails. Sizing and rebalancing discipline matter more than point estimates.
The strategist’s bottom line
Markets are efficient at pricing what they can model and hedge; they are less good at pricing what they have chosen to forget. The Fed can stabilize plumbing and smooth demand shocks, but it cannot pump oil, rebuild bridges, or undo sanctions. The economy can adapt, but adaptation takes time and capital and often lifts the price level in the process.
None of this guarantees a negative outcome. De-escalation can happen, supply proves resilient, and policy can thread the needle. But the distribution of outcomes is wider than market prices suggest. In a world where finance, technology, and security policy are increasingly intertwined, a modest, persistent geopolitical risk premium is not alarmism; it is prudence.
