Excessive Optimism
European equities declined over the past week, while the S&P 500 remains roughly at the same level as before the outbreak of the war in the Middle East.
The relatively stronger performance of U.S. equities over the past week is understandable to some extent. Oil prices have risen sharply, and the United States is largely self-sufficient in energy, whereas Europe relies heavily on imported oil and gas. The question, however, is why U.S. equities have not declined at all. Several explanations may account for this:
- First, for some time financial markets have assumed that productivity will increase significantly during the course of this year as a result of the growing application of AI. Markets have been reinforced in this belief by the strong productivity gains recorded over several quarters in 2025. However, it remains unclear whether these gains can largely be attributed to AI or whether they mainly represent a correction following the extremely weak productivity growth in the period after the outbreak of the COVID pandemic. Many experts believe the latter explanation is more likely, whereas markets appear to place greater emphasis on the impact of AI. If the markets are correct, higher energy prices in the United States may have a limited impact on inflation. Inflation could then remain relatively low, giving the Federal Reserve room to lower interest rates further.
- Second, Donald Trump has indicated that the United States is prepared to use the U.S. Navy to escort, protect, and insure ships passing through the Strait of Hormuz. This has increased confidence that the supply of oil and gas could improve again in the near future, potentially leading to a significant decline in energy prices before long.
- More generally, markets increasingly assume that the war will not last long. Partly due to statements by Trump and his Secretary of Defense, many believe that Iran will not be able to withstand the combined military strength of the United States and Israel for long. Some even expect that this could lead, in the not-too-distant future, to the emergence of a government that is considerably more favorable toward the West.
However, there are several reasons why this assessment may prove overly optimistic.
- As noted earlier, many experts do not expect productivity growth to accelerate significantly in the coming years. In addition, a number of specialists believe that the U.S. Navy is currently not in a position to effectively protect ships passing through the Strait of Hormuz. The cost of insurance is also an important factor: war-risk insurance premiums are currently about twelve times higher than normal. Moreover, many shipping companies are unwilling to allow their vessels to transit the Strait of Hormuz due to concerns about crew safety.
- Most military analysts and historians do not expect that a favorable regime change can be achieved through air strikes alone. Such an outcome would also require substantial “boots on the ground,” something the United States and Israel are reluctant to commit. It does appear possible, however, that an arrangement could be reached with Iranian Kurdish forces, which are well trained and capable of rapid deployment. The question remains what such forces could realistically accomplish. Iran is a highly complex country composed of many groups with different religions, histories, and cultures, which often have deep-seated conflicts among themselves. Liberation of part of Iran by Kurdish forces could therefore quickly lead to widespread instability that may be difficult to control.
- In an attempt to maximize regional instability, Iran has also launched attacks on several other countries in the Middle East. This could easily lead to further escalation—an outcome that Tehran may be seeking in the hope that global public opinion will increasingly turn against Trump, potentially forcing him to end the war.
- At the same time, the U.S. economy has been growing relatively strongly in recent months. Growth is being supported by both accommodative monetary and fiscal policies, as well as by a significant positive wealth effect resulting from rising equity and real estate prices. In addition, the labor market remains tight, while the growth of the labor force is limited due to population aging and Washington’s restrictive immigration policies.
Taken together, these factors could cause inflation to rise rapidly if higher energy prices persist and productivity growth does not accelerate as expected. Moreover, a growing body of research indicates that U.S. import tariffs have so far largely been absorbed by American importers. These firms are likely to seize any opportunity to pass those costs on to consumers.
This must also be viewed against the backdrop of the important U.S. congressional elections scheduled for November. Trump and the Republican Party will likely do everything possible to ensure that economic growth is as strong as possible by that time. From that perspective, proposals may emerge to sell part of the strategic petroleum reserves or to subsidize gasoline purchases for consumers.
All of these measures are aimed at sustaining strong economic growth in the near term. As a result, even if events in the Middle East do not significantly drive inflation higher, inflation could still increase if companies begin passing import tariffs on to consumers.
Our conclusion is therefore that inflation risks in the United States—especially in the context of strong economic growth—could emerge from two directions: higher energy prices and the delayed pass-through of import tariffs to consumers. This suggests that markets may still be placing too much emphasis on the prospect of Federal Reserve rate cuts and too little on the possibility that interest rates may in fact need to rise.
Such a development could have negative consequences for bonds, real estate, and equities, while potentially supporting the U.S. dollar. This would be particularly likely given that Europe is more severely affected by higher energy prices than the United States.
We will discuss these issues in more detail in next week’s GFM report.
