UBS: If the Middle East conflict persists for several months, the global economy could enter a deep recession, and the S&P 500 may fall to 5350 points.

Ask AI · Why does a surge in oil prices nonlinearly increase the risk of an economic recession?

A widening Middle East conflict is pushing global energy markets toward a critical point, and the macroeconomic consequences could be far beyond what markets are currently pricing in. UBS warns that if the crisis extends into the second half of this year, most major economies worldwide will face recession risks, and the S&P 500 could drop sharply from current levels to 5,350.

According to Pursue-the-Trade Trading Desk, UBS’s global economic and strategy report released on March 26 states that the conflict has now entered its fourth week, with ten countries directly involved. The blockade of the Strait of Hormuz has disrupted about 20% of global oil and gas flows. Global oil inventories are being depleted at approximately 9 million barrels per day, and the report expects the fastest decline to reach historical lows by late April.

UBS notes that current market pricing still reflects expectations that the conflict will be resolved soon—credit spreads narrowing, earnings forecasts barely revised downward, and continuous inflows into global equity ETFs. This optimistic outlook starkly contrasts with the actual pressures in energy markets.

If the crisis persists, the combined effects of an energy shock and tightening financial conditions will trigger highly nonlinear downside risks to the economy, posing a significant shock to global investors.

Three Scenarios: From Short-Term Disruption to Deep Recession

UBS outlines three potential paths.

Scenario 1 (Five-Week Disruption): The conflict is resolved in early April; Brent crude briefly spikes to $120 per barrel before falling back. The macro impact is limited, and the S&P 500 is expected to rebound to 7,150 by year-end.

Scenario 2 (Two-Month Disruption): Oil prices peak at $130 per barrel. Global growth declines by about 30 basis points relative to the baseline. The S&P 500 drops toward 6,000 in the second quarter and gradually recovers, ending the year around 6,900.

Scenario 3 (Prolonged Disruption): The conflict continues until the end of the third quarter. Brent oil remains around $150 per barrel throughout the year. Global growth falls nearly 100 basis points below the baseline. The S&P 500 hits 5,350 in the second quarter and can only see substantial recovery in 2027.

The report emphasizes that the impact of oil-price shocks exhibits significant nonlinear characteristics. UBS’s models show that oil at $150 per barrel causes about three times the economic damage of $100 per barrel; if the probability of recession increases by 20 percentage points, the shock’s magnitude could be amplified up to five times.

Inventory Shortages: Nonlinear Upside Risks for Oil Prices Are Approaching

The Strait of Hormuz remains nearly closed. UBS’s energy team estimates that even after accounting for pipeline replacement capacity from Saudi Arabia and the UAE, Iran’s remaining export volumes, and strategic reserve releases, the global market still faces a supply gap of about 9 million barrels per day—currently only covered by rapidly depleting inventories.

At the current rate, global oil product inventories are expected to fall into the lowest third of their historical range within this week; if the situation continues, they could reach historic lows by late April.

Historical experience shows that when inventories are near critically low levels, oil prices tend to rise in a highly nonlinear manner—the buy-side demand driven by precautionary purchases significantly amplifies upward price momentum. UBS notes that in this scenario, Brent could rise toward $150 per barrel or even higher.

Additionally, the model has not fully incorporated the secondary shocks to fertilizer and food prices. The region accounts for about 30% of global fertilizer exports. Sharp increases in energy prices will transmit through fertilizer costs to global food prices. UBS estimates this could add roughly 50 basis points of inflationary pressure for developed economies and up to 240 basis points for emerging markets.

Inflation Surges, Central Banks’ Policy Paths Diverge Significantly

Inflation impacts are relevant across all three scenarios. Even in the mildest five-week disruption, global inflation could rise by about 50 basis points this year; in the two-month and prolonged disruption scenarios, the increases could reach approximately 90 and 190 basis points, respectively.

UBS expects major central banks’ responses to diverge markedly.

The European Central Bank faces a tight labor market, a single inflation mandate, and policy rates already near neutral. In mild shock scenarios, it is inclined to hike rates rather than cut. Even under prolonged disruption, UBS expects the ECB to only modestly reverse previous rate hikes, maintaining a more conservative stance than the Federal Reserve.

In contrast, the Federal Reserve faces a stagnating labor market and policy still within a restrictive range. The new chair may be more cautious about raising rates amid economic weakening. UBS believes that under the prolonged disruption scenario, if the U.S. economy enters recession, the federal funds rate could fall to the zero lower bound by the third quarter of 2027.

The Bank of England’s stance is between the two, but closer to the Fed’s. The Swiss National Bank could re-enter negative territory under prolonged disruption. Japan’s central bank is expected to complete its last rate hike this year, then abandon its tightening cycle and follow the Fed into easing.

Equity Markets: Asia and Europe Hit Hardest, Defensive Sectors Outperform

Before the conflict, markets were in a typical early-cycle rotation—shifting from large caps to small caps, from growth to value, and from the U.S. to global markets. Credit spreads were at extremely low historical percentiles. This positioning was based on a mild growth-inflation outlook, but the oil-price shock is directly eroding that premise.

In the prolonged disruption scenario, the target for the S&P 500 is about 5,350, implying the 12-month forward P/E ratio compresses from roughly 22x to about 18x. U.S. large caps relative to small caps, Europe, and emerging markets may show more resilience, but their absolute performance will also face downward pressure.

Because the Strait of Hormuz is a key energy shipping route for Asia, Asian equities are most affected. European markets are also notably weaker than the U.S., weighed down by natural gas exposure.

Historical patterns show that sectors most impacted by oil supply shocks are consistent: automobiles; consumer durables and apparel; financial services; and capital goods are the weakest performers. If liquidity tightens further in the two-month scenario, U.S. high-yield bond spreads could widen to 600 basis points, further amplifying downside risks in equities.

Fixed Income: Short-Term Value Emerges; U.S. Treasury Long End Rises Then Falls

UBS believes fixed income is the earliest asset class to show investment value in this cycle. Short-term rates across markets have already been significantly repriced, reflecting concerns that central banks may need to hike further to prevent inflation expectations from becoming unanchored. However, UBS considers this scenario’s probability relatively low, expecting the inflation shock to mainly impact headline inflation rather than core inflation.

In all scenarios, the yield on the U.S. 10-year Treasury is expected to peak in the second quarter of 2026, alongside the 2-year yield. The yield curve will flatten in the short term in a bear-steepening/flattening pattern, but over the medium term, it will shift toward bull steepening. Under prolonged disruption, the 10-year yield could eventually fall to 2.50%, but that is a story for 2027.

Germany’s 10-year yield approaches a peak near 3% in all scenarios. UBS recommends going long on German bunds with a target of 2.75% and a stop-loss at 3.15%. UBS sees the most value currently in short-term rates in Switzerland, the UK, the U.S., and India.

The Dollar Remains Strong Short-Term, Weakens Mid-Term; Gold Awaits Growth Fears to Take Over

In the initial volatility phase, the dollar will continue to serve as the primary safe-haven currency, especially against Asian emerging-market currencies.

However, under the prolonged disruption scenario, as the Fed shifts toward aggressive easing, the dollar will face downward, trend-like pressure from late 2026 through 2027. EURUSD could fall to 1.10 before year-end. The yen may also weaken amid concerns over Japan’s fiscal situation and the Bank of Japan’s policy shift, with USDJPY rising to 175.

Recently, gold has been suppressed by rising real yields and a stronger dollar, limiting its traditional safe-haven role. But UBS expects that once growth fears outweigh inflation worries and global yields begin declining, gold prices will regain upward momentum.

UBS suggests viewing $4,000 to $4,250 as the medium-term allocation range for gold. Industrial metals like silver, platinum, and palladium, which are more sensitive to growth, are likely to face more downside in a growth-downturn scenario.