The Iran war has impacted global asset pricing. Goldman Sachs believes that the market’s pricing of monetary tightening has significantly overshot, and a stock market rebound does not necessitate waiting for the crisis to be fully resolved—only clarity on the limits of downside risks is required.

Dominic Wilson, Goldman Sachs’ chief cross-asset strategist, noted in a recent report that since the outbreak of the Iran conflict, the market has primarily characterized this shock as a large-scale “hawkish policy shock” rather than a growth shock, leading to a significant upward repricing of interest rates across major economies. This pricing reflects a clear misjudgment in magnitude, with notably asymmetric downside risks in policy rate expectations.

At the same time, historical experience shows that stock market recoveries often do not require waiting for a crisis to be fully resolved; it is sufficient for the market to confirm that downside risks have peaked. For example, during the COVID-19 pandemic and tariff shocks, equities bottomed out before economic pressures peaked. Although current market pricing is already more pessimistic than baseline scenarios, it may still understate the probability of a U.S. recession and more adverse oil price scenarios.

In terms of cross-asset allocation, once tail risks diminish, U.S. and European equities, U.S. Treasuries, and European currencies will benefit first. In more adverse scenarios, European assets, the Japanese yen, and low-yield positions offer relatively better hedging value.

The market direction is broadly correct, but the “hawkish magnitude” exceeds fundamentals.

The market volatility triggered by the Iran war aligns broadly with macroeconomic fundamentals—rising risk premiums, weakening cyclical assets, pressure on energy-consuming nations, and higher inflation and interest rate pricing. However, there are two notable discrepancies between market reactions and fundamental forecasts in terms of magnitude and structure.

The first, and most significant, discrepancy lies in the extent to which monetary tightening has been priced into the market, far exceeding historically reasonable levels. Historical patterns show ambiguity in the directional impact of oil supply shocks on interest rates, as growth drags and inflationary pressures offset each other. Yet this time, markets swiftly incorporated rate hike expectations for multiple major economies, driving front-end rates sharply higher. A decomposition model of growth and policy shocks indicates that this crisis so far represents a large-scale hawkish policy shock, with relatively mild growth impacts.

The second discrepancy is that assets performing well before the conflict have generally fallen more than fundamental forecasts suggest, indicating additional amplification effects from position unwinding, affecting interest rate markets, some non-U.S. stocks, currencies, and gold.

Rate hike pricing has overshot, creating “asymmetric” downside risks for interest rates.

The current market’s pricing of the distribution of policy rates is misjudged, with significant downward risks showing notable asymmetry. The market has already priced in almost all major economies’ expectations for rate hikes, with front-end out-of-the-money put options in the US, Eurozone, and UK implying breakeven points corresponding to multiple rate hikes this year. However, weighted average policy rate forecasts are lower than forward pricing, with the gap being particularly pronounced in the US and Europe.

Historical experience shows that after oil price supply shocks, policy rates tend to rise slightly within one to three months but fall back as growth concerns mount six to nine months later. During the 1990 oil shock, markets significantly priced in hawkish policy risks, but the Federal Reserve eventually cut rates substantially. This time, inflation concerns may prove excessive in the face of downside risks to growth and upward pressure on unemployment, especially in the US, though the same applies to the European Central Bank.

Until oil prices stabilize, yields may still face upward pressure, and the market will struggle to escape this dynamic in the short term.

Growth pricing is below baseline but does not reflect tail risks.

In terms of growth pricing, Goldman Sachs believes that the implied market pricing for US growth over the next 12 months is about 1.3%, which is below its own baseline forecast but may not yet fully reflect a more adverse oil price scenario.

Vulnerabilities remain in growth pricing. If a more adverse oil price scenario materializes, the market has not yet fully reflected this tail risk. Additionally, the tightening of global financial conditions—driven by rising interest rates—is sufficient to support meaningful downward revisions in growth. If this trend continues or intensifies, the actual growth impact could exceed current assumptions.

Although current pricing is clearly skewed toward pessimism, it may not yet fully incorporate a 30% probability of a US recession or the risks associated with a more adverse oil price scenario.

A stock market rebound does not require ‘problem resolution,’ only ‘peak impact.’

In crisis scenarios, the most intense market rebounds often stem from the narrowing of downside tail risks rather than the complete resolution of the crisis. From the experiences of the COVID-19 pandemic and tariff shocks, stock markets typically bottom out before the worst moments of the real economy arrive—the forward-looking nature of equities far exceeds that of physical markets.

At a price-to-earnings ratio of 25 times, even if…$S&P 500 Index (.SPX.US)$A full year’s worth of profits has been written off, and even with no change in the risk premium, the market discount is only about 4%. This implies that even if substantial economic damage persists, stock markets often need only to see the boundaries of the impact to form a bottom – a “vague resolution path” can also trigger a rebound.

The most direct trigger lies in some degree of de-escalation of the conflict, even though the risk of supply disruptions will persist. In most scenarios, oil prices will structurally remain above pre-war levels, and the terms-of-trade shock can only partially reverse.

Cross-asset allocation: Three axes determine beneficiary assets

The cross-asset allocation framework revolves around three main axes: assets benefiting from narrowing tail risks, assets benefiting from improved terms of trade, and assets benefiting from policy easing.

In a mitigated scenario, interest rates and equities will rebound simultaneously, volatility will drop sharply, and the US dollar will weaken. Relative to implied volatility from options, long positions in US and European equities, credit, European currencies (including CEE-3 currencies), and US Treasuries offer the best value. Additionally, Korean and Japanese equities, as well as certain US cyclical sectors that have seen unusually large declines, present notable rebound potential; if clear signals of policy easing emerge, interest-rate-sensitive sectors such as homebuilders may outperform, and gold also has upside potential.

In the medium term, assets benefiting from terms of trade include UK, Australian, and Brazilian equities, the Brazilian real, the Australian dollar, the Mexican peso, and commodities like copper and gold.

In more adverse scenarios, European assets (equities, foreign exchange, and credit) retain relative hedging value across most downside scenarios; if the market shifts toward broader recession concerns, the yen will strengthen, low-yield positions will become more attractive, and the Australian dollar, Canadian dollar, and some high-yield emerging market currencies will serve as hedges against the US dollar and yen, while copper faces greater downward pressure.

Cross-scenario consensus: Bonds exhibit a “smile curve,” while long-term equity volatility remains subdued.

Across all scenario paths, two judgments are relatively universal and do not depend on specific crisis resolution methods.

First, there exists a “smile curve” structure in interest rates. Whether due to a pullback in hawkish pricing under a mitigated scenario or growth panic in a deeper recession scenario, bonds – particularly G10 short-end rates – and the yen are expected to benefit. This structure suggests that bond yields are likely to decline under various outcomes.

Second, long-term equity volatility and credit spreads may structurally increase. In most forecast paths, including the baseline scenario, long-term equity volatility will continue to rise, and credit spreads will also widen.

In terms of tail hedging, European assets stand out in both upside and downside scenarios; in deeper downside scenarios, strategies involving shorting cyclical currencies (such as the Australian dollar and Canadian dollar) against the US dollar and Japanese yen will become more attractive.

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Editor/Melody