Middle East Hostilities Prompt Investors to Price in 'Long Grind' Conflict

As hostilities in the Middle East flare up again, investors are increasingly grappling with the possibility of a prolonged conflict and pricing in a "long grind."

The latest escalation comes after U.S. Central Command struck Iranian military targets, drawing retaliation from Tehran, which attacked Gulf countries on Thursday.

U.S. futures were up, though markets in Asia were broadly lower. Oil, which was last up about 2% Thursday, has stayed below $100 a barrel as traders still see enough buffers in the market to prevent a full-blown supply shock.

Despite disruptions to shipping through the Strait of Hormuz, alternative export routes, increased U.S. energy exports and strategic petroleum reserve releases have helped cushion the blow.

For investors, the bigger challenge may be a world in which energy costs remain elevated, while borrowing costs stay high. The Iran conflict, which the U.S. said will not be an "endless" one, looks like getting increasingly protracted, if not turning into a "forever war."

"The forever war label puts the emphasis in the wrong place. Wars rarely run forever, but risk premiums can," said Billy Leung, investment strategist at Global X ETFs.

"With mediation collapsing and strikes resuming, markets have moved from pricing a ceasefire to pricing a long grind," he said.

As each new exchange of strikes makes a diplomatic resolution look less likely, markets are bracing for a longer conflict. The result may not be a sharp downturn, but it could be something more lasting: a world in which investors demand a higher premium for geopolitical risk, even after the headlines fade.

Leung said that investors are no longer treating the conflict as a temporary inflation shock. Instead, markets are repricing the cost of capital in a world of elevated geopolitical uncertainty.

"A prolonged war ends the era of buying everything and being rewarded," he said. "With energy costs and the real cost of capital both rising, earnings hurdles move higher across the board."