By Dhara Ranasinghe
LONDON, March 31 (Reuters) - Battered financial markets enter the second quarter significantly exposed to war headlines, a backdrop that could prompt a bigger retreat for equity markets while a hefty selloff in bonds could tempt buyers back.
Even if a resolution to the conflict boosts near-term sentiment, damage inflicted on Middle East energy infrastructure and higher for longer oil prices will still hurt economic growth and drive up inflation, investors expect.
It's a backdrop
that could prompt a bigger retreat for equity markets, while a more protracted conflict that sees growth worries outpace inflation angst could prompt a recovery in bonds.
"It's difficult to look through the noise when the noise is all we have," said Seema Shah, chief global strategist at Principal Asset Management, which manages roughly $594 billion.
"We've been pushing towards international (stocks) exposure and that continues to make sense, but it doesn't mean you close off your exposure to the U.S."
War in the Middle East tops a turbulent first quarter, with markets also whipped around by U.S. President Donald Trump's intervention in Venezuela, threats over Greenland, and AI disruption.
Oil is the clear outperformer, surging roughly 90% this quarter to above $100. That's jolted bond investors, who have ramped up interest rate-hike expectations.
So long as current supply disruptions are sustained, analysts polled by Reuters estimate oil prices between $100 and $190, with an average forecast of $134.62.
Online prediction market platform Polymarket gives a roughly 36% chance of the war ending by mid-May, and a 60% chance by the end of June.
Chiming with 2022's inflation surge, Britain and Italy's short-dated borrowing costs have jumped 75 basis points each this quarter. U.S., German and Japanese bond moves are also significant.
"In all the historical oil shocks, only two things matter: one, the duration of the shock and second, the central bank reaction, which defines the broader risk appetite," said Societe Generale multi-asset strategist Manish Kabra.
Since the Iran war started, traders have priced out U.S. rate cuts by year-end. In the euro area, they expect three rate hikes and at least two in Britain, having previously expected easing. An emerging markets monetary easing push has been short-circuited.
Kabra said one focal point for markets could be the May U.S. Memorial Day holiday weekend, the start of a heavy travel season that could see pressure from consumers on policymakers to contain energy costs.
He has increased asset allocation to commodities to 15% since the war started from 10% before, reflecting the growing link between geopolitics and commodities.
BONDS ARE REELING, STOCKS COULD CATCH UP
In bond markets, where prices have tumbled and yields surged as investors brace for higher inflation and rates, some investors expect pullback.
Francesco Sandrini, head of multi-asset strategies at Amundi, said Europe's biggest asset manager had increased exposure to short-term euro zone government bonds and maintained exposure to five-year U.S. Treasuries on a view that fixed income could perform well once a solution to the crisis emerges.
"In other words, we expect central banks will try to look through short-term price pressure," Sandrini said.
Bonds were looking more attractive than a few months back, said Russell Investments' global chief investment strategist Paul Eitelman, adding that dollar strength was unlikely to be sustained over the medium term.
The dollar has reasserted itself as a safe haven, rallying over 2% in March.
Before the war, investors had diversified away from U.S. assets to other markets, weighing on the dollar, and this theme could return if the conflict ends, analysts said.
Gold, meanwhile, has eased 4% in March. While the safe haven typically rallies at times of inflation angst, it has weakened as investors tap profitable trades to make up for losses in other assets.
While stocks have held up relatively well, thanks to strong earnings and the tech boom, selling pressure has increased recently.
The S&P 500 and Europe's STOXX 600 index are down 9-10% from recent record peaks, while Japan's Nikkei has slid almost 13% from February's record high.
Zurich Insurance Group's chief market strategist Guy Miller said he had moved to an underweight position on equities from overweight before the war as the economic outlook darkens.
U.S. consumer sentiment fell more than expected in March, German investor morale has collapsed and S&P Global's March Purchasing Managers' Indexes for the euro zone and U.S. - forward-looking business activity indicators - hit multi-month lows.
While a strong economy and its energy exporter status buffer the United States, it too will take a hit if the conflict keeps energy prices elevated, analysts said.
The global economy has now been knocked off a stronger growth path, the OECD warned last Thursday.
"This (war) is unlike the geopolitical and political surprises we have seen over the past year, which had a negligible impact on earnings, margins and market multiples," said Zurich Insurance's Miller.
(Reporting by Dhara Ranasinghe; Additional reporting by Amanda Cooper, editing by Yoruk Bahceli and Susan Fenton)
