The Iran conflict has entered its fifth week, evolving in a more complex and protracted manner than initially anticipated by the market. Last week, trading was influenced by the "TACO" narrative and expectations of de-escalation, leading to a retreat in oil prices from their highs. However, the conflict intensified again on Friday, indicating that a genuine resolution may still be distant, and the path to de-escalation is unlikely to be smooth.
Against this backdrop, different asset classes have shown significant divergence in performance. U.S. Treasuries and gold have experienced limited volatility, even posting slight rebounds, while equity markets, such as U.S. stocks, have begun to "catch down" with declines. This aligns with our findings in last week’s report, "Has the Market Fully Priced in Iran Risks?", which concluded that bonds and gold have priced in more pessimistic expectations, while equities have not fully accounted for adverse scenarios.
At this juncture, the key question for investors is: Has the market fallen enough? To answer this, the primary factor is whether the situation escalates further. Additionally, even amid uncertainty, assessing whether assets are fully priced is crucial. Moreover, varying degrees of pricing across different assets and sectors result in significant differences in their risk-reward profiles. These considerations are vital for investors navigating the evolving situation and making allocation decisions, which we will explore in detail.
The trajectory of the Iran situation: April is a critical juncture, determining whether it remains a "paper disturbance" in financial markets or becomes a "real shock" to actual production.
While the outcome remains highly uncertain, two key observation points are important: first, the month of April, and second, production activities in Southeast Asia.
► First, April serves as a watershed in current market expectations. As of March 29, Polymarket betting odds indicate only a 2% probability that the conflict will end by the end of March. There is approximately a 40% chance it concludes by the end of April, and another 40% probability it persists beyond the end of June. Market expectations for a swift resolution have clearly diminished, with a higher likelihood of the conflict dragging on through April or even longer.
► Second, April is also a critical period for potential escalation. The U.S. administration has delayed actions targeting Iranian energy facilities by 10 days, until April 7. Furthermore, the postponement of a key international meeting originally scheduled for March 31–April 2 to May 14–15 indirectly suggests that, from the U.S. perspective, the situation might be manageable by then, underscoring April's importance.
► More importantly, oil tanker supply to East Asia is expected to tighten significantly by early April. Estimating based on the common economic speed of VLCCs (Very Large Crude Carriers) at 12-14 knots, the voyage from main loading ports in the Persian Gulf through the Strait of Hormuz to various East Asian destinations typically takes 10 to over 20 days (e.g., approximately 16 days to the Strait of Malacca, 20 days to China's east coast, 24 days to Japan). Including loading, unloading, and port scheduling, the delivery cycle can approach one month. This implies that tankers that passed through the Strait of Hormuz before the late February escalation have largely reached their destinations. A supply shortfall is anticipated from late March/early April onward. While floating storage, strategic reserves, and alternative sources can act as buffers, if the Strait of Hormuz remains completely blocked by early April, the risk of tightening supply and even localized shortages could materialize.
Southeast Asian nations, with their low reserves and high dependence on external supply, represent a critical "weak link." Countries like Thailand, Vietnam, Indonesia, and the Philippines have begun implementing work-from-home measures. Myanmar has instituted odd-even vehicle restrictions, and a major supplier in Cambodia announced a suspension of LPG supply. As key destinations for Chinese exports in recent years and important links in the supply chain, Southeast Asian countries are prioritizing energy for production, as seen in Vietnam.
If energy shortages lead to reduced or halted industrial production in Southeast Asia, it could severely impact market expectations for global economic prospects and the resilience of Chinese external demand. This would transform the current "paper disturbance" confined to financial market trading and expectations into a "real shock" to economic production, potentially triggering stagflation or even recessionary trading.
Divergence in asset pricing: Bonds, gold, and copper reflect relative pessimism; equity markets generally underprice adverse scenarios.
Compared to the opaque situation itself, the degree of pricing in assets is more measurable and serves as a key anchor for response measures.
As analyzed in our previous report, the benchmark and bridge for measurement is the market's expectation for Federal Reserve interest rate cuts. Currently, CME interest rate futures have pushed the expected start of rate cuts to December 2027. Translating this delay into an implied view on the situation suggests it would require oil prices to sustain above $100 per barrel—meaning the conflict persists into the second half of the year—to justify such a delayed timeline. Conversely, if the conflict does not last into H2 and oil prices don't remain above $100, the Fed could still cut rates based on the current U.S. inflation trajectory and actual growth, even if fewer and later. This highlights the extreme pessimism currently priced into futures markets.
Using this reference, decomposing the expectations priced into different assets reveals significant disparities. Specifically, the implied Fed rate cuts over the next year embedded in various assets are: Fed Dot Plot (-1 cut) > S&P 500 (-0.7 cuts) > Nasdaq (-0.2 cuts) > Gold (+0.1 cuts) > Dow Jones (+0.3 cuts) ≈ Rate Futures (+0.3 cuts) > U.S. Treasuries (+0.8 cuts) > Copper (+0.9 cuts).
In summary, bonds, gold, and copper are relatively pessimistic; equity markets generally underprice adverse scenarios (except for previously hard-hit markets like the Hang Seng TECH Index), which aligns with last week's divergent asset performances.
Has the market reached its bottom? Equity markets may still not have fully priced in pessimistic scenarios.
Returning to the initial question, the answer depends primarily on how the situation evolves. However, based on our analysis of asset pricing, we can draw the following conclusions:
► If the conflict does NOT evolve into the pessimistic scenario of lasting into H2 with oil above $100, then assets that have priced in excessive pessimism—such as U.S. Treasuries, gold, and even the Hang Seng TECH Index—may offer attractive risk-reward profiles should de-escalation occur. Copper, while also pricing in pessimism, ranks lower due to its additional sensitivity to demand.
Under this scenario, downward pressure on equity assets would ease. However, significant upside potential, absent scarring effects, would still require fundamental support. In other words, aside from deeply sold markets like the Hang Seng TECH Index, most equities have not priced in deep pessimism, limiting their potential upside and elasticity. Even without the Iran disruption, we previously expected China's credit cycle to turn broadly flat in 2026, constraining overall index upside—a reason we did not raise our targets further during the market exuberance earlier this year. Additionally, the weak seasonal pattern of the credit cycle in Q2 could bring periodic pressure. Therefore, some investors choosing to slightly reduce positions and wait for clarity or add later is a reasonable strategy.
► Conversely, if the situation deteriorates toward the pessimistic scenario, showing signs of prolonging and impacting real production, markets could quickly shift to stagflation or even recession trading. While all assets would likely face some impact, equity markets, with their generally inadequate pricing of pessimism, might come under greater pressure. In such a case, only cash (USD or reduced positions) and defensive allocations (like low-volatility dividend stocks or low-priced shares) might offer better protection.
Equity markets' general under-pricing of adverse scenarios stems from two factors: first, lingering hope for the "TACO" logic, suggesting potential compromise by the U.S. administration under mid-term election pressure—a plausible speculation; second, the impact of high oil prices and geopolitical shocks on earnings takes time to materialize, as cost, demand, and order pressures transmit gradually, lagging valuation adjustments.
1) U.S. Equity Market: Could still face 8-10% downside in a pessimistic scenario. S&P 500 valuations still incorporate some rate cut expectations, and earnings have not fully reflected the impact of sustained high oil prices. Our previous analysis suggested a potential ~10% correction if the situation escalates persistently, partly validated by last week's "catch-down" decline. If the conflict ends within Q2, valuations could recover, but H1 oil price increases would still weigh on earnings. We modestly lower our year-end S&P 500 target from 7600-7800 to 7100-7200.
2) Chinese Market: A-shares and Hong Kong stocks also do not fully price in pessimistic scenarios. On one hand, the suppressive effect of volatile U.S. Treasury yields and the USD on valuations isn't fully reflected, especially for more liquidity-sensitive H-shares and A-share growth/small-cap styles. On the other hand, if disruptions from a closed Strait of Hormuz affect Southeast Asian production, rising recession fears would transmit through demand logic along the "external demand - cyclicals - tech" chain: global demand weakness would narrow the scope for China's pricing advantages, pressuring export sectors like chemicals and machinery first; pressure would then spread to cyclicals like copper and aluminum via demand and supply; finally, tech valuations would be affected via rates and risk appetite. Recent adjustments in some export and cyclical sectors reflect the beginning of this transmission, but index-level pessimism is not fully priced.
Our estimates suggest that if the situation escalates persistently, keeping oil around $100 into Q3/Q4, the likelihood of Fed rate cuts this year would diminish significantly. Assuming no Fed cuts this year, corresponding year-end 10-year U.S. Treasury yield could be around 4.2%; a 50% increase in oil prices (with a 0.5 pass-through coefficient) could reduce corporate profits by about 12.5%; and risk premium increases (referencing the Russia-Ukraine conflict transition) could lead the Hang Seng TECH Index to fall ~4% to 4500-4600 and the Hang Seng Index ~7% to around 23,000. Different A-share indices would face varying pressures depending on their valuation and earnings exposures.
How to allocate and respond? Build positions early in fully-priced assets, hold beneficiaries but avoid chasing highs, hedge volatility with low-volatility dividends or reduced exposure.
The Iran situation remains unclear, but we assign some confidence to the following premises: First, short-term volatility, especially in April, is likely to persist, with market expectations swinging and periodic escalation possible. Second, medium-term, an outright失控 remains a non-base case. Third, even ignoring Iran, Q2 is inherently a seasonally weaker period for China's credit cycle.
Given this, a more effective allocation approach focuses on probability and payoff, seeking assets with favorable risk-reward. Specific strategies include:
► For investors with low exposure, consider early positioning in assets that have fully priced pessimism, are highly sensitive to rates/risk appetite, and trade at depressed valuations after significant declines—e.g., the Hang Seng TECH Index, gold, innovative pharmaceuticals. These may not be the strongest performers short-term, but with expectations already low, further downside is limited. They are likely to recover first if tensions ease or extreme scenarios fail to materialize. Such assets suit gradual, early accumulation.
► For those with higher exposure, consider modestly reducing positions amid short-term noise or allocating to defensive, low-volatility dividend stocks as a hedge. Q2's weak credit cycle, combined with external geopolitical shocks and demand uncertainty, suggests the overall market isn't pricing deep pessimism. Moderating exposure can mitigate potential volatility without sacrificing much upside. Banks, utilities, and stable cash-flow, high-dividend stocks can serve as defensive core holdings. While lacking high elasticity, they help reduce volatility and control drawdowns when markets lack clear direction.
► Hold sectors benefiting from supply shocks and energy security themes, like energy storage and coal; this is already a consensus trade and appears crowded, suggesting caution against chasing highs. If energy prices remain elevated, reinforcing resource security narratives, these sectors naturally attract attention. However, high expectations and crowded positioning (near 100th percentile historically) mean subsequent risk-reward may be less attractive. Additionally, if sustained high oil prices drive fertilizer and food inflation, agricultural commodities warrant gradual attention.
From a short-term, purely quantitative rotation perspective, our sector rotation model currently favors technology hardware, internet, chemicals, building materials, and steel based on profit, valuation, and trading momentum—suitable for priority consideration. Banks, biotech, and non-ferrous metals show strong fundamentals but lower trading scores, suggesting monitoring for medium-term core or early-stage allocation. Conversely, coal, oil & gas, and utilities appear somewhat crowded near-term. This model is based solely on short-term data reflecting sector conditions and serves as a supplementary tool alongside long-term fundamental logic; chasing sectors already at high crowding levels is not advisable.
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