Worse than inflation: BofA lays out a disruptive scenario that markets haven't priced in yet

• Inflation fears are rising amid the Iran war, but investors might not be pricing in a more disruptive scenario.
• That's according to BofA, which said that investors should consider the risk of a global downturn.
• The S&P 500 has only dipped slightly since the war began, as traders see a muted impact from the conflict.

Rising inflation has emerged as the market's biggest fear from the Iran war, but Bank of America analysts think there's a more disruptive impact investors may be overlooking.

Oil-price spikes driven by the ongoing conflict in the Middle East have fueled inflation worries, with Brent crude continuing to hover at $100 a barrel for the last week. Yet, while much attention is being paid to the potential for prices to rise, Bank of America said that the market isn't factoring in a bigger risk: a synchronized global slowdown driven by a more prolonged war.

Bank of America analysts said they think the likelihood of the conflict extending into the second quarter is just as high as a quick resolution.

"The most important factor for the global economy is how persistent energy and uncertainty shocks are," they wrote wrote.

And yet, despite the relatively high odds of a longer war, the market is still largely treating the event as a transitory shock.

The S&P 500 is down only slightly since the war began. This could be seen as a demonstration of market resilience, or, in BofA's view, that investors aren't pricing in the most disruptive scenario.

The Strait of Hormuz, a critical bottleneck for global trade, has been in focus. With a significant share of global oil traveling through the strait, shipping disruptions have driven up oil prices, which ultimately are expected to feed into inflation.

Bank of America flagged that beyond shipping disruptions in the strait, there is a more impactful scenario for the global economy that it sees.

"The major risk to markets, beyond shipping, remains the possibility of permanent losses of energy production in the Gulf depending on the degree of Iranian retaliation," they wrote.

Since the US is less dependent on the Middle East for oil, the energy shock would have a larger impact on Europe and Asia, but the scenario would play out in the stock market and hurt the tech supply chain.

"Further (supply-driven) WTI increases could be a headwind to S&P 500 and an already struggling lower income consumer," the bank said.

Markets, meanwhile, have been more focused on central bank actions as the war drags on.

The Federal Reserve will announce its latest interest rate decision on Wednesday. Markets expect officials to leave rates unchanged, and investors will be listening for any indication about how the central bank is thinking about inflation in the context of the war and higher oil prices.