U.S.-Iran negotiations fail – what’s next?

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The Iran war: A fragile ceasefire

Credit spreads narrowed close to their historic tightest despite the Middle East conflict

Source: Bloomberg

Last week, markets gained for a second consecutive week, and credit spreads narrowed despite the single most important driver of market sentiment – the evolving situation in the U.S.-Iran war.

When European investors departed for the Easter weekend, President Trump’s deadline for the reopening of the Strait of Hormuz was hanging over markets. The president had promised to unleash a wave of strikes against power and desalination plants if the Strait wasn’t reopened by Easter Monday. That deadline was extended to 8pm local time last Tuesday (1am on Wednesday in the UK).

Shortly before that deadline, it was announced that a ceasefire agreement had been reached, which became the week’s defining moment. The ceasefire, agreed between the U.S. and Iran, is conditioned principally on the reopening of the Strait of Hormuz to commercial shipping. Iran confirmed the Strait would be ‘navigable’, but the details remain deeply contested.

The Iranian idea of an open Strait seemed to require transit fees, which is something that multiple regional and global consumers of Gulf oil have refused to consider, complicating the path to a durable resolution.

By the time European markets opened, it was clear that this ceasefire was imperfect. There was confusion over the terms, suggestions that the parties had agreed to different drafts and disputes over whether the ceasefire extended to action in Lebanon. Several countries have refused to negotiate transit with Iran, and President Trump has made clear that transit fees are not part of the agreement. As a result, shipping didn’t meaningfully resume in the Strait ahead of scheduled talks between Iran and the U.S. in Islamabad, Pakistan over the weekend.

Disagreements extend beyond the issue of transit fees, with Iran also demanding reparations for war damage.

By the beginning of this week, the emphasis had changed, with President Trump instead choosing to impose a blockade on vessels bound for Iranian ports. U.S. officials announced this has prompted Iran to make contact again, and new talks are rumoured to be taking place this weekend.

What are the possible outcomes?

Helima Croft of RBC Capital Markets outlined three possible scenarios:

• The divide between Washington and Tehran’s negotiating positions proves too difficult to bridge and fighting resumes.
• A deal is reached that largely meets Iran’s established enrichment and missile priorities and comes with the added bonus of control of the Strait of Hormuz.
• A no-peace, no-hot-war pause of indeterminate duration emerges that renders the ultimate security of the region’s waterways unsettled.

The resilience of equity and credit markets would suggest that investors are not positioned for the first option. The extending deadlines, erratic social media posts, and lack of response to reports of ceasefire violations suggest that the U.S. is reluctant to escalate military action further, possibly due to the humanitarian or political consequences.

The central purpose of the initial action was to prevent Iran from achieving the capability to produce a nuclear weapon, but Iran now demands the right to enrich uranium without supervision. It seems inconceivable that the U.S. could agree to that, as it would mark a huge backward step from the Joint Comprehensive Plan of Action (JCPOA) agreement, which President Trump pulled America out of in 2018.

By Friday, there had been no meaningful commercial traffic transiting the Strait of Hormuz since the ceasefire was announced. Oil prices remained within touching distance of $100 per barrel, underscoring the continued tightness in energy markets.

Equity and credit markets remain strong

It may be surprising against this backdrop that equity and credit markets have remained resilient. For context, markets found stability prior to the ceasefire agreement, reflecting the fact that many investors reduced risk during the early weeks of the war.

Markets continue to enjoy inflows from relatively robust employment levels and companies are buying their shares back. Under such circumstances, the risks facing investors start to shift, with the potential for them to be under exposed to any good news – for example, Friday’s story that Ukraine’s top negotiator believes a potential peace deal with Russia is within reach.

European currencies and bonds all directly benefit from any easing of hostilities. UK bonds in particular offer the highest yields in the G7 because of the tendency to have higher interest rates. Policy is slightly restrictive already, so there’s a weaker case for interest rate increases.

Despite such high yields, the predominantly long-dated funding of the UK means that it has been protected to some extent from the sharp increases of bond yields in recent years. So, despite its bond yields being the highest in the G7, the rate it pays (the coupon on its bonds) is close to average.

Yields for investors and costs for issuers

Source: Bloomberg

As we’ve previously noted, the UK bond market and sterling closely reflect the economic reality of the UK economy, however the UK equity market is more international and very diversified across sectors. The relatively high weightings in defensives and energy mean that it will remain more defensive than other equity markets if conflict intensifies, and it will benefit less than other major European markets from an easing of hostilities.

Coming up

• Earnings season: First-quarter earnings will be released for several companies this week, kicking off, as always, with the banks, but also including Dutch semiconductor equipment maker, ASML.
• Informed views: The International Monetary Fund (IMF) publishes its World Economic Outlook and Global Financial Stability reports this week.
• China data: Gross domestic product (GDP), industrial production and retail sales will be released by China on Thursday. The economy has struggled to maintain momentum recently and is exposed to higher energy prices and disruption from the war in Iran.

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