CIO continues to see a hedging value in both gold and oil as geopolitical risks remain elevated. (UBS)

The latest developments provoked a relatively muted response in safe-haven assets, with both gold and oil little changed on the day. The yield on 10-year Treasuries, which have largely failed to serve their customary role as a safe haven this time, also remained relatively stable.

Our base case is that a broader escalation of the war will be avoided. But the situation in the Middle East remains in flux and markets’ risk assessment could change quickly. In addition, beyond geopolitics, we see reasons to add exposure to Treasuries, while both gold and oil can provide hedges against near-term volatility:

Beyond safe-haven demand, Brent is well supported by supply-demand dynamics. If Iran's involvement were to lead to a fall in the country’s oil exports, this could put pressure on an already constrained market—with a 500,000 barrel a day reduction potentially taking Brent crude prices to between USD 100 and USD 110 per barrel, from around USD 90 at present. In addition, a broadening of the conflict across the region could cause prices to spike as high as USD 120, in our view.

In the medium term, we believe such significant moves higher in the oil price would ultimately be countered by an increase in production from OPEC+ and could also undermine consumer demand. As a result, we expect Brent to trade at a USD 90–100 per barrel range over the coming months, and forecast a year-end target of USD 95. However, the situation in the Middle East does increase the appeal of oil at present as a way of mitigating potential portfolio volatility. In the medium term, rising global demand and constrained supply also limit the downside for crude, in our view.

Gold should remain a good hedge, despite worries that rates will remain higher for longer. The price of the metal has climbed by about 9% since the Hamas attack on Israel and a regional escalation of the conflict would likely boost gold further.

While we believe that safe-haven flows would eventually reverse, the metal has proven its worth as a diversifier again. In addition, we ultimately see support for gold as the slowing US economy allows Federal Reserve officials to move toward monetary easing—which would likely lead to lower yields and a lower opportunity cost of holding the non-interest-bearing metal.

Demand for US Treasuries would likely rise in the event of an escalation, and they are well-supported by economic fundamentals anyway. So far, US government bonds have not been performing their usual safe-haven function. Instead, investors have focused on more resilient US economic data—which has added to worries that the Fed will keep rates higher for longer. However, an escalation of the conflict would likely shift attention away from monetary policy concerns and boost safe-haven demand for Treasuries. We would also expect any rise in the oil price caused by a military escalation to add to fears of pressure on consumer spending, potentially adding further to demand for Treasuries offsetting any worries over the inflationary impact of higher oil prices.

Over the medium term, we expect the 10-year Treasury yield to be driven mostly by a weakening US economy and the prospect of lower policy rates: The potential for a safe-haven boost adds to their near-term appeal.

So, we continue to see a hedging value in both gold and oil as geopolitical risks remain elevated. As a result, we advise investors retain existing long positions in gold and consider buying dips in crude oil. US Treasuries, which we expect to benefit from slowing US growth, could also be in heavier demand if events in the Middle East deteriorate. That said, our base case is that elevated geopolitical risk premiums will not last too long, so investors should add to hedges only judiciously.

Read the original report: Hedging the risk of Middle East escalation, 26 October 2023.