Markets have started to digest the Israel-Iran conflict, and U.S. equities opened higher. But has the danger truly passed?

According to Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, there are still three major ways the Middle East conflict could negatively affect equities.

1. Valuation Compression

The first concern is that the Israel-Iran escalation could reduce the multiples investors are willing to assign to equities. Just as we saw during episodes of economic policy uncertainty, military conflict tends to compress price-to-earnings (P/E) ratios for the S&P 500.

Calvasina warns that investors must remain cautious about the risk of valuation decline. In April, during the tariff retaliation episode, the S&P 500’s valuation briefly dipped before rebounding to historical highs. High valuations leave stocks more vulnerable to negative surprises.

2. Damaged Sentiment

The second issue is that rising geopolitical tensions may damage investor, consumer, and business sentiment—just when confidence had been recovering from trade war concerns.

In previous earnings calls, events such as California wildfires, bad weather, and even flu outbreaks were mentioned as headwinds to consumer sentiment and spending. Expect to hear Middle East tensions come up during Q2 earnings calls as well.

3. Oil, Inflation, and the Fed

The final concern is the inflationary pressure from rising oil prices. RBC’s commodities strategists see significant further upside in Brent crude. Should oil continue to climb, U.S. inflation could rebound sharply—forcing the Federal Reserve to delay rate cuts or even consider hikes.

This would be a major blow to equities, which have been supported by expectations of rate cuts.

RBC’s valuation model illustrates how higher inflation, as measured by the core Personal Consumption Expenditures (PCE) price index (the Fed’s preferred inflation metric), could drag down the S&P 500. The bank assumes a 4% core PCE rate, just two rate cuts in the rest of 2025 (each of 25 basis points), and the 10-year U.S. Treasury yield staying at 4.45% through year-end.

Under these assumptions, and depending on the EPS forecast used, RBC’s model shows a fair year-end 2025 S&P 500 range of 4,800 to 5,200—possibly retesting the lows seen earlier in 2025. With the S&P 500 closing at 5,977 last Friday, this implies a potential 13% to 20% downside if RBC’s forecast proves correct.