JP Morgan's trading guru says the market is underappreciating the risk of a conflict with Iran

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The U.S.-Iran conflict appears to be in the rear-view mirror as stocks soar to record highs and the phase one signing of the U.S.-China trade deal takes center stage, but some are warning that tensions in the Middle East continue to simmer, and may soon reach a boiling point.

“A significant change to our outlook is the new geopolitical tail risk that emerged in the Middle East,” Marko Kolanovic, global head of macro quantitative and derivatives strategy, said in a note to clients Wednesday. “We believe this tail risk is under-appreciated by the market and should be hedged.”

Tensions between the U.S. and Iran escalated after the U.S. conducted an airstrike on Jan. 2 that killed top Iranian commander Qasem Soleimani, and then when Iran subsequently retaliated on Jan. 7 by firing missiles at multiple bases in Iraq that housed U.S. troops.

For a moment stocks fell and oil moved higher as the Street considered whether or not Iran would target production in the oil-rich region.

But stocks quickly recovered their losses and then surged to all-time highs, while oil finished the week ending Jan. 10 with a more than 6% loss — its worst week since July — as supply disruption threats faded.

Kolanovic’s reports have moved markets in the past and he’s made some good calls on equities by analyzing various quantitative factors such as fund flows and volatility. For example, he predicted the big rotation into value stocks last year.

While Iran tensions appear to have cooled, Kolanovic argues that the underlying issues were not resolved, which means the risks were not removed, but instead push the US and Iran “further down a collision course.”

Given that an election year is underway in the United States, Kolanovic said that ongoing retaliation from Iran could have an especially acute impact since volatility and climbing oil prices could contribute to foreign policy decisions.

“If the conflict were to escalate in an election year, causing market turmoil, and with the US having fewer allies, Trump could be more likely to accept a JCPOA-like settlement,” he said, adding that “the risk of escalation is high going into U.S. elections” and that “the market currently is not pricing any significant risk.”

– With reporting from CNBC’s Michael Bloom.

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