Europe and the Iran conflict: 4 critical considerations for investors

1. How is the conflict impacting Europe?

The conflict in the Middle East, while first and foremost a human tragedy, also represents a supply shock for the global economy that will intensify the longer the war goes on. For Europe, a prolonged conflict would be particularly challenging, as it would represent the third major shock in just over five years after the COVID pandemic and the war in Ukraine.

A prolonged war would further undermine the region’s competitiveness at a time when many of its key industries are already reeling from high energy costs and intensifying competition from China.

If the conflict were to end relatively swiftly, the global and European economies could still emerge largely unscathed, albeit with some lingering scar tissue. However, the longer it continues, the greater the risk of more lasting damage. In the worst-case scenario, this could lead to 1970s-style stagflation.

Looking back at our key expectations for the year, we anticipated:

1. a likely pick-up in growth on the back of loose monetary policy, fiscal expansion and (mostly) US deregulation;
2. higher-than-expected inflation in the second half of the year; and
3. recession and stagflation as tail risks at most.

Now, even in the best-case scenario, inflation is likely to pick up more and sooner than predicted while growth momentum is likely to stall, if only temporarily. A longer-lasting conflict would obviously worsen these outcomes. European consumer confidence, while structurally underpinned by large savings balances, is a key variable to watch here, as it could help to tip the economy from a slowdown into recession.

2. What does this mean for Europe’s regime change?

Leaving aside the most extreme scenarios, we do not think this supply shock fundamentally alters the path of Europe’s regime change. If anything, the closure of the Strait of Hormuz is another pressing reminder that Europe urgently needs to reduce its dependence on external inputs, whether energy imports, the US defence umbrella or China’s willingness to purchase the region’s high-end goods.

Consequently, we think the conflict is likely to reaccelerate Europe’s shift from an international, export-led economic model to a more domestically focused economy.

We are already witnessing signs of that acceleration, supported by growing pragmatism within the European Union (EU), most notably from Germany. Rather than being an obstacle to reform, Germany is now seeking to take the lead with a smaller group of member states in key areas such as the removal of intra-EU trade barriers, the creation of a unified capital market and the establishment of a more stable and secure energy supply.

In turn, this ongoing regime change is creating additional investment opportunities in sectors such as:

• Infrastructure. Since Russia’s invasion of Ukraine, Europe has taken significant steps to diversify its energy supply. However, this supply shock highlights that as well as diversifying supplies, Europe needs to reduce its reliance on energy imports. That means further accelerating investment in renewables as well as improving both the storage capacity and the interconnectivity of the European grid, so that excess energy can be easily rerouted to where it is needed most.
• Defence. The current conflict is likely to provide further impetus to increase European defence capabilities in areas such as the production of drone and missile interceptors and advanced AI-based technology.

3. How will policymakers react?

This crisis presents central banks with a difficult conundrum. Raising rates too early could worsen any potential downturn. Waiting too long, on the other hand, could de-anchor inflation expectations and ultimately necessitate more rate hikes. Europe’s policymakers face a particularly challenging set of circumstances, given still-fragile business and consumer confidence, deteriorating competitiveness and constrained public finances.

When and how far central bankers will raise rates depends on:

• the intensity and duration of the conflict;
• the scale of the fiscal response to alleviate the pressure on consumers and businesses; and
• the resulting impact on growth and employment.

Policymakers will also have to navigate increased concerns relating to debt sustainability and potential political pressure at a time when inflation expectations are at risk of becoming de-anchored, most notably in the UK. At the same time, we can expect greater divergence in policy, as the fallout from the conflict varies across the region. Our bias is that the European Central Bank is more likely to move faster and do more than the Bank of England initially, given its more singular focus on inflation and the lessons learnt from the relatively late start to the hiking cycle in 2022.

4. How does this compare with the AI disruption?

Alongside the fracturing geopolitical world order, AI is arguably the largest global disruptor. Here again, Europe appears to be on the back foot, lacking the major AI and technology enablers that have driven much of the US growth story.

However, the AI disruption may be less damaging for Europe than this supply shock as the next stage of AI development is not just about who builds the technology, but who uses it effectively. The gap between Europe and the US in the adoption of AI tools is far from insurmountable, with several European countries among the world’s top AI users.¹

Many European companies are large incumbents with data, scale and established customer bases that can be harnessed. For them, AI is less about disruption and more about improving efficiency, reducing costs and supporting margins. Europe also has many HALO (heavy assets, low obsolescence) stocks, such as utilities and telecommunications companies, which underpin much of the region’s critical infrastructure.

Taken together, this suggests that the region may be less vulnerable to the large-scale job destruction that AI may cause in the near term. While the eventual macro impact of AI is hard to gauge, there is now a clear opportunity for Europe to lift its productivity² and mitigate some of the damage that a potentially long-lasting conflict in the Middle East could cause.

Implications for investors

Given the potentially binary set of outcomes of the US-Iran war — a near-term cessation or a drawn-out conflict — and the widely differing implications for European economies, sectors and securities, we advocate increased selectivity and diversification.

Fixed income
In our view, there is a risk that European central banks may have to raise rates more than markets expect, which may be a source of near-term instability. We also expect a growing focus on debt sustainability given rising debt-servicing costs and likely fiscal support for consumers and businesses. We are also closely monitoring any political risk that could derail Europe’s reform momentum.

Equities
In the medium term, we expect the European market’s rotation from large international growth stocks to domestic value stocks, including banks and small- and mid-cap equities, to continue, but there may be short-term pullbacks as asset prices do not yet fully reflect the deteriorating economic outlook. We see near-term opportunities in sectors such as utilities, renewables and other types of infrastructure related to increased energy security and digitalisation.

In essence

The US-Iran war is an increasingly material supply shock for Europe, but it may ultimately accelerate ongoing regime change. We therefore maintain our structurally positive view on European assets, albeit with a heightened focus on diversification and selectivity. We are also encouraged by signs that Europe may be better placed for the next stage of AI, as it could give the region a much-needed productivity boost and create a virtuous cycle of longer-term opportunity.

¹“Global AI adoption in 2025”, Microsoft AI Economy Institute, 8 January 2026. | ²“AI adoption, productivity and employment: Evidence from European firms”, BIS Working Papers No 1325, Iñaki Aldasoro, Leonardo Gambacorta, Rozalia Pal, Debora Revoltella, Christoph Weiss and Marcin Wolski, January 2026.