Markets have responded calmly to renewed hostilities in the Middle East, continuing to assume that any disruption will be short-lived. This week's update examines whether investors are becoming too complacent about geopolitical risk and explores how both oil markets and the AI investment cycle could challenge prevailing market assumptions.
This week we witnessed the fragility of the Memorandum of Understanding as hostilities resumed between the USA and Iran over the Strait of Hormuz. As a result, the oil price rose back to over $70 a barrel. It is interesting to note how sanguine the market has been over the Middle East conflict, both in the equity markets and in the oil price, given how quickly the oil price declined when the ceasefire was announced. It is interesting to note how the markets have effectively ignored the geopolitical risk. A question we ask ourselves as investors is, are we becoming too complacent? Is there a risk of a tipping point, and the market will become less sanguine about prolonged supply disruptions in the Strait of Hormuz? Currently, the market is pricing in the most benign outcomes, and is ignoring any tail risk, until it is forced to.
Given the troubles in the Middle East, we have been monitoring oil inventories globally. As of the end of June, the US Strategic Petroleum Reserve (SPR) is holding ~325-340 million barrels of oil. The current reserves are well below the long-run average and are near the lowest levels seen in the last 40 years. Given that the US has reduced reserves, we could see a scenario where the Fed has a harder trade off if an energy shock lifts inflation. With a limited SPR, the Fed cannot rely so much on strategic releases to dampen prices, pushing it towards either tolerating higher inflation, or tightening more aggressively into a supply shock. Also, at current strategic reserve levels, adversaries to the US know that there is a higher probability that energy shocks bite faster, which can embolden coercive strategies like Iran leveraging the Strait of Hormuz.
Looking ahead, earnings season kicks off next week, and while the general trend of earnings will be important, the biggest focus will be on the results of the large US technology companies, and in particular how much they plan to spend building out AI infrastructure. As we know, over the last several quarters, their spending estimates have been revised higher, and that has helped boost confidence in the AI investment theme. Consensus has US hyperscalers’ capex at ~$800bn in 2026, increasing to $1.2trn in 2027. It would be a risk though if we learn from the 2Q results and guidance that there is a hesitation to continue the cadence of spend that we have so far seen. This question over the capex and cash flow forecasts of the hyperscalers is particularly pertinent, given that token prices are continuing to decline and AI models from China are gaining ground competitively, both in their share of being the world’s most used models and in token usage, where they lead their US rivals.
In conclusion, the current market backdrop reflects a high degree of confidence that geopolitical disruptions will remain short-lived and ultimately inconsequential for the global economy. While markets have been conditioned to face such risks, the distribution of outcomes appears skewed, with too little weight assigned to prolonged or structurally disruptive scenarios, both at the macro level and within equities, where the AI theme has become increasingly dominant.
