Still a Wall of Worry, not a brick wall

With the Iran conflict now in its fourth week, headline risk has become a constant feature of the market backdrop: disruption in shipping through the Strait of Hormuz, day-to-day shifts in rhetoric and military posturing, and the associated volatility in spot oil. As we noted at the outset of the conflict, we at Federated Hermes are treating this episode as another brick in the Wall of Worry as the US markets advance toward our single-digit total return S&P 500 target for 2026 of 7,500.

Our thought process assumes the conflict is contained and ultimately resolves without a prolonged disruption to global energy supply. In that potential outcome, we expect investors to return attention to reaccelerating US GDP growth, expanding earnings and a gradual compression in the market multiple. We anticipate “asset-light” companies to become more like their “asset-heavy” peers due to higher AI capital spending and broader AI-driven disruption. At the same time, investors will have to contend with that other brick flying around — liquidity stress in portions of the retail private credit markets. That’s an area in which banks’ direct exposure appears limited, but where contagion risk bears watching.

Still, as the conflict persists, and the potential second- and third-order effects on the global economy become clearer, we are introducing three scenarios for how the future state may evolve. Like any three-dimensional chess game with multiple skilled players, the number of possible scenarios expands with each escalation or de-escalation. With that caveat, we see: (1) a base case broadly consistent with our March 3 memo, The Wall of Worry gets another brick, albeit with a somewhat higher structural oil-price floor and thus more potential risk around our price target; (2) a bull case with regime change in Iran leading to lower oil prices and accelerating global growth, though likely only after a deeper near-term correction; and (3) a downside case in which the conflict escalates substantially, generating a sharper drawdown before an inevitable, though delayed, recovery.

Base case A quick end to the conflict and a return to our previous baseline growth expectations

This case is close to the framework we outlined in our February memo, The good news and the bad news, published just days before the Iran conflict began. It assumes that the conflict ends in the coming weeks, leaving a weakened Iranian regime in place. In that outcome, the global economy would presumably revert toward its pre-conflict state: accelerating US GDP growth on the back of fiscal stimulus from the One Big Beautiful Bill, deregulation and robust business investment driven by the AI infrastructure buildout, and reshoring activity stemming from the tariff wars. The survival of the Iranian regime, however, would likely mean that any positive impact of the reopening of the Strait of Hormuz would likely be tempered by the persistent risk that the regime could close it in the future.

It is difficult to precisely estimate the impact on the energy risk premium from an ongoing risk to energy flow through the Strait. While roughly 20% of global oil flows through it, some portion is less exposed than the headline number suggests. Roughly 7% is Saudi crude that can be rerouted via Red Sea ports and another 2% represents Iranian crude that is continuing to flow (to China) through the Strait. Even so, in a “quick resolution” scenario, 11% of the world’s crude supply would remain subject to the ongoing uncertainty of a resurgence of the Iranian regime. We therefore expect a structural increase in oil demand, as governments and corporations around the globe look to build larger energy reserves. Our working assumption is that Brent crude settles closer to a $70-$80 per barrel range versus the $60 level that prevailed pre-conflict.

Given the structural disinflationary forces we have outlined in previous commentaries, it seems more likely that a one-off increase in oil prices would impact US GDP growth more than core inflation, i.e., the higher prices would impact the economy more as a consumption tax than a persistent inflationary impulse. As a net energy exporter, the US should be comparatively insulated, while growth abroad would likely moderate at the margin. Net-net, we continue to view this scenario as another brick in the Wall of Worry rather than anything else.

At present, we assign approximately a 70% probability to this base-case outcome. A quick end is in the economic and political interest of both sides. For the Trump administration, a prolonged conflict risks higher gasoline prices and a deeper equity drawdown that will likely lead to more political pressure on the president to find a way out. Likewise, for the Iranian regime, an extended war likely would compound its already severe economic stress — and make it more difficult for the regime to remain in power. So, a quick conclusion seems the most likely outcome. Accordingly, our investment strategies continue to be oriented toward the base case despite elevated near-term headline risk. We are holding our pre-conflict GDP, earnings and market targets unchanged (S&P 500 at 7,500 for 2026 and 8,200 for 2027).

Bull case Iran regime change leads to a reacceleration in global growth, but only after a deeper market correction

Regime change in Iran would be the most constructive long-term outcome for global markets. It would likely compress the longer-run energy-risk premium, improve investor confidence and reduce the probability of recurring energy supply shocks. It could also temper broader geopolitical risk taking, assuaging some of the US market’s intermediate-term concerns around Taiwan. Under this scenario, trend growth could re-rate higher versus our current baseline and we could see a return to the disinflation trend that persisted pre-conflict, creating room for three to five additional Federal Reserve rate cuts over the next 24 months. In that environment, we could see our two-year 2027 S&P 500 target of 8,200 pulled forward by a year.

That said, we view this as a lower-probability outcome given the operational and political complexity of regime change. Iran is a large country whose land mass, riddled with mountains and valleys, is four times larger than countries such as Iraq and Germany. Its standing army of over half a million soldiers further exacerbates the challenge of a takeover, even from within, absent some element of the military switching allegiance to what is left of the disorganized Iranian protest movement. Few in history, absent Alexander the Great, have managed to conquer and hold Iran/Persia — ask the Roman Empire or the Ottoman Empire. However, given the uncertain alignment of its internal power centers and the existential nature of this conflict for the forces that currently hold power in the country, for a transition to occur the conflict would likely have to rage on considerably longer. We assign only a 15% probability to this scenario.

The bad news for markets is that, even if the long-term picture would be brighter under this scenario, the path would likely involve an escalation of the fighting, with an invasion of Kharg Island and/or broader destruction of Iranian energy infrastructure likely. As a result, this bull-case could coincide with a materially deeper equity correction. So even this relatively positive scenario argues for patience in terms of adding further to our equity exposures.

Downside case The conflict widens and intensifies, leading to deeper near-term damage to growth, inflation and earnings — the brick wall

Distinguishing between a “Wall of Worry” and a true “brick wall” is difficult ahead of time, though plenty of bears emerge whenever the latter seems to appear on the horizon. The bears have predicted hundreds of brick walls over time that have failed to materialize. Of course, when one does arrive, the bear becomes famous for the rest of their lives!

In the present instance, a brick wall outcome could emerge if the Iranian regime, facing existential risk to its survival, escalates the conflict. In other words, a scenario enabling the Houthis to meaningfully disrupt Red Sea transit while also targeting regional oil processing and export infrastructure. While such actions would likely ultimately prove self-defeating for Iran, the near-term impact on energy prices could be severe, particularly if Saudi export capacity become even more severely constrained. In that case, oil could spike well above $150 per barrel, pushing the global economy into a temporary stagflationary environment, which is the bane of equities. Our current S&P targets would be too high for that environment, at least over the next several quarters. Currently, we think the probability of this scenario is relatively low, about 15%.

More importantly, like most doomsday scenarios, even this brick wall would not likely prove permanent. For one, it would be self-correcting as a large enough shock would accelerate policy, diplomatic and — if necessary —military responses from countries around the globe to restore supply over time. Moreover, given the healthy state of the Western banking system and the strength of corporate and household balance sheets, we would only expect a “plain vanilla” short-term correction in the 15–20% range rather than a deeper and protracted bear market. Given the relatively low probability of this case and the even lower chance of a protracted bear market, our advice is to not position portfolios for this potential outcome.

Bottom line We recommend staying disciplined to wait out the storm. While the news flow out of the Middle East appears grim at times, the preponderance of evidence still supports a Wall of Worry framework rather than a brick wall. We are therefore maintaining our base-case targets and positioning our portfolios accordingly.