Recent global equity declines of 5% since military actions involving the U.S. and Israel against Iran are considered "broadly reasonable" from a macroeconomic perspective. However, analysis indicates significant underlying structural mispricing, with equity markets in several countries becoming oversold relative to fundamentals. Models suggest recent market rotations reflect pricing of recession risk rather than stagflation concerns. The probability of recession has surged to 35%, up sharply from 10% two weeks prior, while the implied probability of stagflation remains unchanged at 8%. This shift aligns with cyclical sectors underperforming defensive sectors by 9% since mid-February. The potential for the "largest physical supply disruption in oil market history" from a substantive closure of the Strait of Hormuz represents a key pressure point for equities. Sensitivity analysis indicates European markets like Germany, France, and the Netherlands could underperform if sustained oil price spikes occur, while energy-heavy markets like Norway, Saudi Arabia, and Canada may demonstrate greater resilience. Some emerging markets appear disproportionately sold off, with South Korea, South Africa, and Indonesia oversold by 5-10%. Valuations in these markets are becoming increasingly attractive, particularly given their limited exposure to oil price increases. Approximately 10% of the UAE market's 23% decline cannot be explained by fundamentals, potentially reflecting geopolitical risk premiums. Investors are advised to focus on materials, industrials, and financials sectors, with specific recommendations including metals and mining, industrial companies, and banks based on their defensive characteristics in potential stagflation scenarios.
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