Middle East Tensions and U.S. Credit Risk: Navigating Geopolitical Volatility in a Resilient Market

The Middle East has once again become a flashpoint for geopolitical risk, with U.S. military strikes on Iran's nuclear facilities in June 2025 igniting fears of a broader conflict. While equity markets have shown signs of strain, credit markets have proven unexpectedly resilient. Investors now face a critical question: How do you position portfolios to capitalize on the strength of U.S. credit markets while mitigating risks from escalating tensions?

A Volatile Backdrop, But Credit Markets Hold Steady

The U.S. decision to target Iran's nuclear infrastructure has raised the specter of supply chain disruptions, particularly through the Strait of Hormuz, a chokepoint for 20% of global oil trade. . Oil prices have surged by 25% since early June, but credit markets have so far resisted panic. U.S. high-yield bond spreads have tightened by 5 basis points to 299 basis points, while European credit indices have shown only marginal widening.

This resilience reflects solid credit fundamentals: U.S. corporations remain in better shape than during past crises, with strong balance sheets and steady earnings growth in sectors like technology and healthcare. Even in energy, where companies have faced rising input costs, credit ratings have been upgraded due to the sector's cyclical upside from higher oil prices.

Key Risks Lurking Beneath the Surface

While markets are not yet pricing in a full-blown crisis, several risks could upend this calm:

1. Oil Price Volatility: A closure of the Strait of Hormuz (Goldman Sachs assigns a 52% probability this year) could push Brent crude to $90–$130/barrel. Such a shock would ignite inflationary pressures, complicating the Federal Reserve's path. .

2. Fed Policy Crossroads: The Fed's June 2025 policy statement held rates at 4.25–4.50%, projecting two cuts by year-end. However, if oil-driven inflation overshoots forecasts, rate cuts could be delayed, tightening financial conditions and widening credit spreads.
   Historically, such decisions have been followed by strong equity performance. A backtest from 2020 to 2025 shows that this strategy delivered a total return of 124%, outperforming the benchmark by 14 percentage points, with an average annual return of 15.76%. While the strategy had a maximum drawdown of 31%, its Sharpe ratio of 1.22 underscores a favorable risk-return profile, suggesting equities often thrive during periods of accommodative Fed policy.

3. Supply Chain Disruptions: Beyond energy, a prolonged conflict could disrupt global trade, squeezing corporate margins and increasing defaults in sectors like industrials and transportation.

Portfolio Strategies for a Geopolitical Crossroads

Investors must balance the current resilience of credit markets with the potential for sudden shocks. Here's how to position portfolios:

1. Favor Resilient Sectors

• Energy and Utilities: These sectors are direct beneficiaries of higher oil prices and are less sensitive to economic slowdowns. .
• Technology and Healthcare: These sectors have shown earnings resilience and lower exposure to energy costs, making them safer havens than equities.

2. Stick with Investment-Grade Credit

Investment-grade corporate bonds offer a middle ground between safety and yield. Their spreads remain tight, reflecting underlying economic strength. Avoid overextending duration, as geopolitical uncertainty makes long-dated bonds riskier.

3. Use Treasuries as a Shock Absorber

While Treasury yields have edged higher (the 10-year is at 4.39%), they remain a critical hedge against macro volatility. A geopolitical escalation could push investors into Treasuries, compressing yields further.

4. Monitor Tail Risks with Inflation Hedges

Gold and inflation-linked bonds (TIPS) are essential for portfolios facing extreme scenarios. . Their demand typically surges when markets price in prolonged supply disruptions or inflation spikes.

5. Reduce Exposure to Emerging Markets and High-Yield Risks

High-yield bonds and emerging markets remain vulnerable to liquidity crunches during crises. While their spreads are tight now, they could widen sharply if the Fed's easing timeline is delayed.

Conclusion: Patience and Pragmatism

The Middle East's turmoil has not yet derailed U.S. credit markets, but investors must stay vigilant. The base case—contained conflict and manageable inflation—supports continued credit resilience. However, the Fed's policy path and Iran's next move remain critical variables.

Position portfolios to capitalize on today's stability while hedging against tomorrow's risks. Prioritize sectors with direct upside from energy prices, maintain a core of investment-grade bonds, and use Treasuries and inflation hedges as insurance. In this geopolitical crossroads, diversification and discipline are the keys to navigating volatility without sacrificing growth.