Trade tensions and global growth concerns have weighed on oil demand since early May. But renewed tensions between the US and Iran, alongside a more dovish Fed and falling US oil inventories, have prompted a 10% spike in Brent crude oil prices since the middle of June.

A significant factor for oil supply/demand fundamentals will be whether OPEC+ decides to extend its output cut agreement into the second half of the year; the cartel and its allies are meeting on 1-2 July to take that decision. But alongside OPEC+’s efforts to balance the oil market, investors should also consider the potential for escalating geo-political tensions to drive crude prices:

* Base case: brinkmanship. We think the Gulf region will experience ebbs and flows of tension without a full-blown military conflict. Recent events suggest neither side has a desire to escalate the conflict further, and both have voiced a desire to avoid war. Iran likely fears US military action, while President Trump strongly criticized the US's military engagement in the Middle East during his 2016 election campaign, and would presumably wish to avoid violent confrontation unless a red line is crossed. But markets are likely to retain a risk premium on oil prices and we forecast Brent crude at USD 70/bbl and USD 67/bbl in six and 12 months, respectively, compared with around USD 66/bbl currently.

* Risk case: Military escalation leading to oil supply disruption. In our view, the likelihood of a military escalation leading to a full-scale crisis remains low, although it has evidently increased given the heightened risk of miscalculation on either side. A direct US–Iran conflict is unlikely, but oil shipments could be disrupted if attacks on Saudi oil assets are conducted and/or if Iran moves to disrupt shipping in the Gulf of Oman or block the Strait of Hormuz, which is the passage for more than 30% of the world's seaborne crude. In a worst-case scenario, oil prices could spike to more than USD 90/bbl, in our view.

While not our base case, during previous significant oil supply shocks, global equities have fallen about 15% on average, but recovered within six months. In credit, high yield and emerging market bonds suffered the most, but recovered within three months. In our tactical asset allocation we continue to overweight equities with a selective regional approach. However, given downside risks such as US–Iran tensions and the US–China trade conflict, we recommend holding counter-cyclical positions as well.