"The implications of developments in the Middle East for the U.S. economy are uncertain."
- Fed Chairman, Jay Powell, 3/18/26
Economic and market conditions were already uncertain before hostilities in Iran: Policy volatility was high, especially around tariffs and Fed independence. Inflation remained “sticky”, putting additional Fed accommodation in doubt. Markets weighed the prospect that AI may radically enhance productivity against AI’s potential cost in terms of lost jobs and capital consumed. The labor market has been softening. Federal debt just reached $39 Trillion as interest on that debt surpasses defense outlays. Now add to this mix a conflict which exceeds the intensity and regional scope of most other US military involvement since the operations in Iraq that began in 2003.
Markets focus on the war and particularly on the status of the Strait of Hormuz. As market pullbacks are an occasional part of equity investing, it would be unusual if these events didn’t result in a correction. Most US stock indexes briefly touched or approached a 10% correction, but by the end of the quarter, both the S&P 500 and the Russell 3000 Index recovered a bit and were each down about 5% from their close on Friday, 2/28, the day before hostilities started. March was the worst month for stocks in four years. For the full first quarter, the Russell 3000 stock index returned -3.95%.
Yet this market reaction may indicate nothing about the future. Consider some history: More than a decade ago, a CFA study found that US stock markets performed a little better in wartime than in peacetime (1926-2013). Moreover, and even more counterintuitive, volatility was also lower. A recent RBC Wealth Management study of 20 significant conflicts since WWII (not all with US involvement), found that on average, the S&P 500 fell 6% from initial market impact to market bottom. Moreover, in 90% of these episodes - 18 of the 20 events - the market recovered to its previous high within a month after the trough.
One of those two events that fell outside the pattern was when Iraq invaded Kuwait and seized its oilfields in 1990. In that case, stocks fell about 16% and it took just over four months and a US-led intervention, Operation Desert Storm, to recover to prior highs. That was non-trivial, but in the broader scheme, was not much of a speedbump for even a moderately patient investor.
The other event in the last 80 years in which the pattern failed, and failed significantly, requires more attention: it was the October 1973 Yom Kippur War and subsequent OPEC oil embargo, and that was a different experience altogether. As an outgrowth of that conflict, oil prices quadrupled, the economy experienced a 17-month-long recession, inflation soared to over 11% in 1974, wage and price controls were enacted, there were gas lines and rationing, and through it all, the Watergate scandal played out, ending in the Nixon resignation. Stocks fell about 48%, most having been quite expensive by most measures before the embargo. This event didn’t correspond to a war with direct US involvement, but it is notable as it started with an oil spike related to hostilities and was one of the three worst periods for US stocks for which we have good records.
This year, crude oil prices have approximately doubled but so far that’s well short of the kind of price move that occurred in 1973-74. And markets don’t expect anything approaching that scale. In fact, while near-term oil futures are trading at about $100/bbl., oil for delivery next March trades under $70/bbl. now. Also, the US was a net oil importer in the 1970s and is a net exporter now. Moreover, oil consumed per unit of GDP is much lower today than 50 years ago. There are still many ways in which the economic outlook could materially deteriorate. But given where things now stand, we see little reason to expect anything very different than the typical post-WWII market reaction to a war.
On the other hand, while war has historically not been a long-term drag on stocks, it has typically been bad for inflation, and hence bad for bonds. Inflation during wartime has run 1.4% per year higher than the overall average, and that is not good for bonds. The Organisation for Economic Co-operation and Development (OCED) recently raised its inflation outlook for the US in 2026 from 2.8% to 4.2%. S&P Global now expects 4% inflation this year. Underscoring these views, 10-year Treasury yields edged up from 3.96% on 2/27 to 4.31% at the end of the quarter.
We’re more concerned about long-term economic pressures than the effects of war, which tend to be shorter-term in nature. In this case, the trends align. Federal debt has grown beyond any likely fixes other than money creation, which would drive inflation. AI’s growth, while promising, would continue to increase electricity consumption, pressuring prices. Demographics in the developed world don’t favor growth. And now war-related supply chain disruptions are impacting not just oil markets, but aluminum and fertilizer too.
There is much uncertainty and considerable market angst now. But one thing modestly improved last month: market valuations. Aggregate stock market earnings are still expected to rise in low double digits this year (up from about a 10% increase last year). Couple that with the fact that so far this year, the Russell 3000 Growth index (the most expensive part of the US stock market) was down nearly 10% in the first quarter, and we are beginning to see some improvement to valuations where it was most needed. Markets are not yet cheap, and they may not get cheap this cycle, but they are less overvalued than before (especially in the market’s most expensive pockets) and that has slightly positive implications for long-term stock returns.
We previously wrote about how broad diversification helped last year even though it was a strong year for stocks as small US stocks performed better than large stocks, international stocks did better than US markets, and market risk hedges and real assets each did well. In spite of a very different environment in the first quarter of this year, each of those themes continues in 2026: small stocks, international stocks, value stocks, and diversifying asset classes are each outperforming so far this year. The net result is managed portfolios are weathering this year’s storm relatively well.
We should also mention private credit which is in the middle of a storm of sorts right now. Private credit has been a great performer for several years, but is currently experiencing some credit and liquidity issues. Importantly, those issues do not seem to be “systemic” (as was the case with sub-prime mortgages in 2008). We have very modest exposure to this type of private credit amounting to one-fourth of one percent of managed portfolios in the aggregate. That kind of conservative sizing makes periodic credit issues essentially a non-event for portfolios.
Going forward, we will continue to rebalance, which allows market volatility to benefit portfolios, and we will maintain broad diversification not just within stock holdings but among different asset classes and currencies. More inflation for longer looks to be the most likely long-term economic outcome, so while we see more risk than upside in market timing shifts, even with bonds, we do see more advantage in shorter bonds than longer in this environment.
We design portfolios to weather the inevitable storms, not to try to steer around them. That allows us to resist the urge to let headlines dictate long-term decisions. Long history has proven that to be a good course to follow.