Three-act market drama

Three-act market drama

The Middle East remained the market’s primary compass throughout May, with traders hanging on every headline, leak, diplomatic whisper, and carefully floated trial balloon suggesting that some form of US-Iran agreement might eventually emerge. As hopes for de-escalation gathered momentum, the geopolitical risk premium embedded in energy markets began to evaporate. Brent crude tumbled 19.3% over the month, its steepest decline since the pandemic panic of March 2020, when global lockdowns brought economic activity to a standstill.

That collapse in oil prices did more than just ease pressure at the gas pump. It effectively dismantled one of the market’s biggest stagflation fears. As energy inflation risks retreated, bond yields moved lower, financial conditions loosened, and investors were given permission to embrace risk once again. The result was another powerful leg higher for equities, with the S&P 500 climbing 5.3% in total return terms to fresh record highs.

Yet beneath the surface, the real story was the return of the AI boom loop. Semiconductor stocks once again became the market’s preferred vehicle for expressing optimism about the future. The Philadelphia Semiconductor Index surged another 22.2% in May alone, pushing year-to-date gains to a staggering 81.5%. The only modern comparison is the final stages of the dot-com era when chip stocks raced higher even faster. But as every trader knows, history rarely repeats exactly. It simply changes costumes before returning to the stage.

The AI fever was hardly confined to Wall Street. In South Korea, one of the world’s most important bellwethers for the artificial intelligence supply chain, the KOSPI surged another 28.5% in May, pushing its year-to-date advance to an astonishing 102.4%. The move was a vivid reminder that the AI boom is no longer a purely American phenomenon. Capital is increasingly chasing the same theme across multiple time zones, turning equity markets from Seoul to Silicon Valley into different stages of the same global performance.

It was not entirely a one-way trade. Sovereign bond yields briefly climbed to multi-year highs mid-month as investors grappled with fiscal concerns and the possibility that higher energy prices could reignite inflationary pressures. But those worries faded as rapidly as they appeared. Renewed optimism surrounding a potential US-Iran agreement helped drive oil prices lower, easing inflation fears and allowing bond markets to recover into month-end. Once again, falling energy prices acted like a release valve for broader financial conditions.

Before diving deeper into the details, it is worth stepping back and viewing May through a wider lens. Deutsche Bank’s Henry Allen argues that the month unfolded as a three-act market drama. The first act was geopolitics, in which hopes for a Middle East peace dividend helped crush oil prices and calm fears of stagflation. The second was the relentless resurgence of the AI trade, which continued to funnel capital toward semiconductors and technology leaders. The final act was the growing tension between powerful structural forces building beneath the surface and a market increasingly willing to price a near-perfect future. Together, those three themes formed the backdrop for one of the most remarkable months of risk-taking in recent memory.

• The first part started strongly, as an Axios report on May 6 said the US and Iran were close to a one-page memo to end the war (it’s almost a month later and the two sides still haven’t agreed on any memo). Oil prices fell sharply, with Brent crude down from $114/bbl on May 4 to $100/bbl on May 7. So stagflation fears eased considerably, particularly as the US jobs report featured another upside surprise for payrolls.
• The second part was more pessimistic, as Trump posted that Iran’s proposal was “TOTALLY UNACCEPTABLE!” So that raised fears of an escalation, whilst a strong US core CPI print added to concern about more persistent inflation, particularly with the Strait of Hormuz still blocked.
• This period saw bond yields hit multi-year highs in several countries. On May 19, the 30yr Treasury yield closed at a post-2007 high of 5.18%, 10yr bund yields hit a post-2011 high of 3.19%, and Japan’s 10yr yield hit a post-1997 high of 2.78%.
• The third part saw optimism return, as multiple reports suggested a US-Iran deal was again close. In fact, oil prices ended the month at a one-month low, the S&P 500 posted 7 consecutive gains, and the 10yr Treasury yield fell for 7 consecutive sessions for the first time in over a year. So the full numbers pointed to a decent performance overall.
• While events in Iran continued to dominate attention, the other big story in May was the return of AI excitement, with chip stocks massively outperforming. For instance, the Philly semiconductor index was up another +22.2%, and the KOSPI was up +26.2% in USD total return terms. That took their YTD gains to +82% and +94% respectively, after just 5 months of the year. In fact, in local currency terms, the KOSPI is up more than +100% YTD. So, despite all the geopolitical volatility this year, the AI story is still center stage for financial assets.

The month the market traded peace, then panic, then peace again

If April was about surviving the shock, May was about pricing the possibility of an exit. Markets spent the entire month swinging between optimism and anxiety as traders attempted to handicap not just the outcome of the Middle East conflict but also the path to get there. Every diplomatic leak, every anonymous briefing, every carefully planted trial balloon became a tradable event. The result was a market that behaved less like a weighing machine and more like a geopolitical seismograph.

The month began with investors leaning heavily into the idea that a US-Iran agreement might be within reach. Reports suggesting both sides were closing in on a framework for negotiations triggered an immediate repricing across asset classes. Oil, which had become the market’s inflation barometer and geopolitical fear gauge, fell sharply as traders rushed to pare the conflict premium embedded in prices. Brent collapsed from above $114 to near $100 within days. At the same time, stronger-than-expected US payroll data reassured investors that economic momentum remained intact. For a brief period, markets appeared to have found the perfect combination: falling oil, resilient growth, and receding stagflation fears.

But markets rarely travel in straight lines, particularly when geopolitics sits in the driver’s seat.

By the middle of May, the narrative had shifted again. President Donald Trump’s increasingly confrontational rhetoric toward Iran revived fears that diplomacy might be stalling. Hopes for a quick resolution began to fade, and with the Strait of Hormuz still constrained, traders once again turned their attention to supply risks. Oil prices started climbing. Inflation concerns resurfaced. Bond markets began to wobble.

The market’s emotional pendulum swung rapidly from relief back toward anxiety.

A stronger-than-expected core CPI report only added fuel to the fire. Suddenly, investors were forced to contemplate a more uncomfortable possibility: what if growth remained firm while energy prices stayed elevated? That combination threatened to keep inflation sticky and interest rates higher for longer. By mid-month, the Brent forward curve was signalling exactly that outcome, with futures markets increasingly pricing a prolonged period of elevated energy costs rather than a temporary disruption.

Bond markets responded accordingly. Sovereign yields pushed to levels not seen in years. The 30-year Treasury yield climbed above 5%, German bund yields reached their highest levels since the eurozone crisis, and Japanese government bond yields continued their historic march higher as investors questioned how much longer the era of artificially suppressed rates could last. Across developed markets, the message from bond traders was remarkably consistent: fiscal reality was beginning to matter again.

Yet just as markets appeared ready to embrace a higher-for-longer inflation narrative, the story pivoted once more.

Late in the month, a fresh wave of reports suggesting progress toward a ceasefire and renewed nuclear negotiations reignited hopes for a diplomatic breakthrough. Investors who had spent weeks pricing scarcity suddenly found themselves pricing abundance again. Oil retreated. Inflation fears eased. Bond yields rolled over. Financial conditions loosened. Risk appetite returned with force.

The final week of May felt like a market exhaling.

Equities embraced the shift immediately. The S&P 500 closed at fresh record highs, extending a seven-session winning streak, while Treasury yields fell for seven consecutive sessions. Investors once again found themselves gravitating toward the market’s favourite story: artificial intelligence.

If the Middle East supplied the volatility, AI supplied the gravity.

The semiconductor complex became the primary destination for global capital flows. The Philadelphia Semiconductor Index surged another 22.2% during the month, pushing year-to-date gains above 80%. The AI boom loop remained firmly intact. Capital spending expectations continued to rise. Earnings forecasts continued to move higher. Investors remained willing to look beyond current valuations and focus instead on the possibility that AI is creating one of the largest productivity cycles in modern economic history.

That enthusiasm spread well beyond the United States. South Korea, arguably the purest public market expression of the global AI supply chain, became one of the biggest beneficiaries. The KOSPI surged another 28.5% in May alone, pushing year-to-date gains beyond 100%. The move was extraordinary, but it also reflected a simple reality: when investors believe a technological revolution is underway, they rarely stop at national borders.

Looking back, Henry Allen’s framework of a three-act market drama feels particularly appropriate. The first act was geopolitics, where markets spent the month pricing war, peace, and everything in between. The second act was inflation, as oil’s wild swings repeatedly altered expectations for growth, yields, and central bank policy. The final act was AI, which continued to absorb capital and investor attention regardless of the macro backdrop.

The performance table tells the story clearly. Equities were the standout winners. The S&P 500 gained 5.3%, European equities rose 3.2%, Japan’s Nikkei jumped 11.9%, and South Korea delivered one of the most spectacular rallies anywhere in the world. Bonds also recovered as stagflation fears faded, particularly in Europe and the UK. The biggest losers were the assets most directly tied to geopolitical anxiety. Brent crude suffered its largest monthly decline since the pandemic. Gold slipped as inflation concerns eased and real yields remained elevated. Bitcoin, which initially benefited from anti-fiat demand during the conflict, surrendered much of those gains as risk appetite returned elsewhere.

For traders, the lesson from May was straightforward. Markets are still trading two stories simultaneously. One is the daily geopolitical headline cycle that drives oil, inflation expectations, and bond yields. The other is the longer-term AI investment boom that continues to pull capital toward technology regardless of the macro noise. Throughout May, those two stories repeatedly collided. More often than not, AI won.