The "Impossible Triangle" of the Strait of Hormuz

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The global market is currently betting on three mutually contradictory propositions simultaneously—risk premiums are at a 20-year low, oil inventories are about to run out, and the reopening of the strait seems far off. Bank of America Merrill Lynch warns that this "impossible triangle" means the market is seriously underestimating the risk of demand destruction.

According to Wind Trading Desk, Bank of America Merrill Lynch strategists led by Sebastian Raedler noted in a report released on May 22 that since the outbreak of the Iran war at the end of February, European stock markets have only fallen by 2%, while global markets have risen 4% and reached historical highs.

The market's tranquility mainly relies on three pillars: the rise in oil prices has been relatively moderate (thanks to previously abundant inventories), US macro data remains resilient (supported by large-scale tax rebates earlier this year), and the AI investment boom has greatly boosted global profit momentum beyond levels implied by macro fundamentals. However, these pillars are gradually being shaken.

Three Propositions, One Contradiction

The report summarizes current market pricing into three mutually incompatible propositions, referring to it as the "Hormuz impossible triangle."

First Proposition: Financial risk premiums are near a 20-year low. Since mid-March, asset prices have rebounded, compressing financial risk premiums back to close to the 20-year lows at the start of the year. The European equity risk premium (ERP) is currently at 4.75%, only 25 basis points above the recent low; US high-yield credit spreads are at 275 basis points, just 15 basis points above the recent low. Driven mainly by global growth momentum, the current level of risk premiums means the market expects the global PMI to rebound moderately from the current level, rather than being dragged down by an energy supply shock.

Second Proposition: Oil inventories will fall to critical lows. Given that oil inventories have been significantly consumed, "restoring energy flows through the Hormuz Strait as soon as possible is critical to preventing a major economic recession." Many market participants believe that at the current rate of consumption, global oil inventories may reach operational pressure levels around June. Once the inventory buffer is exhausted, supply-demand imbalances can only be adjusted through demand destruction—which means oil prices will rise further until demand is suppressed, consistent with the experience of past energy price shocks.

Some investors believe demand destruction will mainly occur in emerging markets, and that the US, as a net energy exporter, can remain unaffected. However, oil is a globally priced commodity, and demand destruction will ripple through to all economies via higher gasoline prices, further depressing the real income growth of US residents.

Third Proposition: Prediction markets see a low probability of the strait reopening soon. According to prediction market platform Kalshi data, the probability of the Hormuz Strait reopening for navigation before the end of June has dropped from 75% at the end of April to about 30%, and only 40% before early August.

Unlike last year’s trade war, the standoff around the Hormuz Strait is a multi-party game. Both the US and Iran believe that waiting for the other side to suffer more first is in their favor, which could prolong the conflict beyond investors’ expectations. The Iranian regime can maintain fiscal operations through limited oil exports and has the capacity to sustain consumption.

The tension between the three propositions is obvious: if the probability of a prolonged closure of the strait is as low as the prediction markets indicate, and inventory buffers are running out, then the market’s pricing of demand destruction risk is overly optimistic.

Macro Resilience Is Fading

Despite calm market performance, macro data has started to diverge. In the US, labor market, consumption, and capital expenditure data have so far remained strong, but the effect of large-scale tax rebates earlier this year has faded. "The real test of consumer and labor market resilience may still lie ahead." The growth rate of real labor income in the US has fallen to recession levels due to inflation pressure from rising energy costs, and US core PCE inflation is expected to remain slightly above 3% in the coming months.

The situation in the eurozone is even more severe. In May, the eurozone composite PMI new orders index fell to a two-year low of 47.1, and eurozone private final demand growth is expected to slow sharply in the coming quarters. European natural gas prices have continued to rise since the outbreak of the Iran war, exerting extra pressure on eurozone PMI.

It is notable that global profit momentum currently still greatly exceeds the levels implied by macro fundamentals—the US 12-month forward EPS 3-month change rate is 8%, Europe is 5%, both the strongest since 2021, mainly contributed by financial, resources, and technology sectors driven by the AI investment boom. However, Bank of America Merrill Lynch expects that as macro pressures transmit, the 12-month forward EPS for Stoxx 600 will fall about 5% from current historical highs, implying a 2026 profit growth rate of -1%, below the market’s consensus bottom-up expectations.

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