The war with Iran is pushing inflation up, keeping interest rates higher, and dampening economic growth, but markets have performed remarkably well. That reflects a resilient economy and rapid growth in corporate profits.
Stocks have experienced ups and downs since the war started but have more than recouped losses and are up for the year, having more than doubled since the bull market began in October 2022. Credit spreads—a measure of market risk aversion—have remained tight. Bond yields have risen since the start of the conflict in response to higher inflation, diminished expectations of Federal Reserve interest rate cuts, and concerns about U.S. budget deficits and debt. Headline inflation has moved up significantly due to the surge in energy prices, while core inflation continues to trend about a percentage point above the Fed’s target of 2%. The Big Beautiful Bill increases federal debt, and the war will add to it further. The Pentagon has asked Congress to set aside $200 billion for the war on top of a record-breaking defense budget request of $1.5 trillion for the coming fiscal year, which would amount to a 50% increase (the biggest since WWII). The Iraq war ended up costing around $2 trillion, and that was when publicly held U.S. Treasury debt was less than $4 trillion; it is now more than $31 trillion.
The U.S. economy has held relatively steady at around 2% real GDP growth, reflecting strong offsetting drivers: reduced immigration and higher tariffs and oil prices are restraining growth, but fiscal stimulus and especially the massive AI investment boom are providing significant positive offsets. This new technology is seen as so critical for future business success that firms are not asking whether they can afford to invest but rather whether they can afford not to. The surge in AI investment is far from over: companies continue to spend hundreds of billions of dollars to build the necessary infrastructure. Investment in equipment and intellectual property—the vast majority of which was AI-related—contributed 75% of the 2% GDP growth recorded in the first quarter of this year. U.S. tech companies are borrowing around $500 billion to finance AI spending as well as another $500 billion from their own cash reserves, an amount that exceeds 3% of US GDP.
The most immediate and significant economic impact of the war is on crude oil prices, which have surged by more than 60%. This creates more revenue for oil producers but increases expenses for most businesses and reduces real disposable income and the amount of money that consumers can spend on other things. Iran produces only around 4% of the world’s oil, but the war has closed the Strait of Hormuz, through which more than 20% of the world’s oil and LNG (liquified natural gas) is supplied.
U.S. consumer spending has held up reasonably well despite the surge in energy prices. That is due partly to fiscal stimulus: the Big Beautiful Bill reduced taxes by some $200 billion, most of which was realized in the tax-filing season that ended on April 15. Consumption has also been bolstered by the recent improvement in the labor market. AI has displaced some jobs, but at this point the enormous spending on infrastructure is creating more jobs than are being displaced. Business taxes were also reduced, including 100% expensing of capital expenditures, providing further impetus to AI spending. Meanwhile, corporate profits continue to grow at a very healthy pace: Company earnings in the first quarter are producing the largest year-on-year increase in over four years.
The economies of other countries are not faring nearly as well as the U.S., which is now the world’s largest energy producer and a net exporter. Asia (excluding China) is being hit hardest because of its heavy reliance on oil exports from the Gulf region. As the war drags on and the Strait remains closed, Asian factories are reducing output due to an energy shortage. Europe also depends heavily on energy imports, and the surge in prices is weakening economic activity there. Flights in both regions are being canceled due to a lack of jet fuel, and airfares are increasing everywhere, as oil from the Gulf region is especially suited for producing the diesel fuel that jets use.
The surge in oil prices has made Russia one of the few winners from the war in Iran. Like the U.S., it is also energy independent, but the state owns a dominant share of its energy resources, which generate around one-quarter of government revenues. China can also get through the war with a lot less pain than most other countries. It produces around 30% of the oil it consumes and is the biggest importer of Russian oil, which is not dependent on the Strait of Hormuz for export. China has also been strengthening its energy security for years: it has accumulated a large strategic oil reserve and accelerated the development of renewable energy. China is the world’s largest electric vehicle producer, thereby reducing its reliance on gas-powered vehicles. Meanwhile, U.S. tariffs have not slowed down the Chinese export engine; Increased exports to other countries have more than offset the reduction in exports to the U.S..
China accounts for 90% of Iran’s oil exports, which are less dependent on the Strait of Hormuz than they were in the past. Iran built a large stockpile of oil on ships out at sea in response to the U.S. and Israeli attacks last June. As a result, it has been able to continue to export oil using so-called “dark fleet operations”, which are difficult for the U.S. blockade to stop. This provides Iran with a financial cushion, making it less willing to concede to U.S. demands.
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This suggests that the war could last longer than expected. Even after the Strait of Hormuz opens, it will take a long time—probably more than a year—before oil prices return to pre-war levels. The release of commercial and strategic oil reserves has been moderating the rise in oil prices, and these inventories are dwindling fast. Even after supply starts increasing again, these inventories will need to be replenished, and market risk premia will remain elevated for quite some time. In addition, dozens of energy assets in the Gulf have been hit by drone and missile strikes, many of which have been severely damaged, including refineries. This means that millions of barrels of oil per day will remain off the market for many months.
The increase in oil prices has created significant negative spillover effects on other industries. The cost of transporting goods by ship or truck has increased, along with air travel. The agriculture industry has experienced higher fertilizer costs, which have raised food prices. Household utility bills are also rising, while higher mortgage rates have compounded the weakness in the US housing industry.
The negative supply shocks of reduced immigration, higher tariffs, and oil prices have put upward pressure on inflation. As a result, the Federal Reserve is unlikely to reduce interest rates for many more months. While a new Chair will soon take the helm of the Fed in response to the President’s displeasure with the Fed’s refusal to lower rates further, most FOMC members are inclined to keep short-term interest rates where they are as long as the economy holds up.
Watch the full Atlas Q2’26 Macroeconomic Update here:
