Managing escalating risks
CIO Daily Updates
From the studio
From the studio
Thought of the day
Thought of the day
The conflict between the US and Iran has continued to escalate into this week. US President Trump overnight threatened to “obliterate [Iran’s] various power plants” if Iran does not “fully open, without threat” the Strait of Hormuz by 19:44 ET on 23 March. Iran's Islamic Revolutionary Guard Corps in response vowed to instead fully shut the Strait until any damaged power facilities are reopened and threatened to target energy facilities in neighboring countries that host US military bases. Early Monday morning, the Israeli military announced a “ wide-scale” wave of new strikes on infrastructure in Tehran.
The price of Brent crude is up around 1.5% at the time of writing to USD 113.8 a barrel, compared to around USD 70 a barrel before the start of US-Israeli airstrikes on 28 February. Gold is facing its ninth straight daily loss, declining more than 5% to around USD 4,250/oz. Asia's equity markets sold down broadly, led by a 6.5% fall for the Kospi and declines of 3.5% for the Nikkei 225 and Hang Seng indices. In Europe, the Stoxx 600 is down 1.7% at the time of writing, while US futures point to a decline of about 0.8%.
Investors face a dilemma, which we described in our CIO Alert, “An investor’s guide to navigating the conflict,” published on 9 March. The longer energy supplies remain constrained, the higher energy prices will go and the worse the economic and market impacts. Concurrently, since equity markets tend to be forward-looking, we would expect a quick rebound on any signs of an end to the conflict and a restoration of energy flows.
To navigate this crisis, we said that investors should stay invested and positioned for upside, as trading geopolitical events is rarely a winning strategy. At the same time, we also said investors should progressively reduce portfolio risks the longer the crisis lasts by hedging, diversifying, and reducing cyclical exposures.
In recent months we have recommended taking steps to diversify, hedge, and reduce risk exposures. Following our downgrades to the US information technology and US communication services sectors in February, we reduced European banks to Neutral. We have also recommended positioning for short-term US dollar upside as a potential hedge.
The latest escalation increases the likelihood that the Strait may remain closed for longer, and with oil, gas, and product inventories running lower in various economies around the world, investors should once again review portfolios.
We believe investors should maintain strategic positions in equities, but (1) reduce excess cyclical exposure in favor of short-duration quality bonds, where we see an increasingly attractive opportunity, (2) add to gold and broad commodity exposure as a hedge against further geopolitical escalation, and (3) hedge parts of their direct equity exposure with capital preservation strategies, where pricing remains appealing given elevated interest rate expectations.
Opportunities to hedge market risks:
Replace excess cyclical equity exposure with short-duration quality bonds, particularly in Europe. Bond markets are now pricing three interest rate hikes by the European Central Bank and two by the Bank of England this year, and no cuts by the Federal Reserve. We believe markets are focused too heavily on the potential short-term inflationary impact of higher energy prices and not enough on the medium-term negative growth impact, which we think could in fact drive interest rate cuts. This creates an opportunity for investors to “lock in” elevated short-term interest rate expectations with short-duration quality bonds.
While we believe investors should maintain strategic equity exposure, we see lowering excess risk exposures in favor of short-duration quality bonds as a potentially appealing way to reduce geopolitical exposure, earn attractive yields, and position for a potential decline in bond yields either if the conflict is resolved, or if markets begin to price a negative growth shock.
Among major global equity markets, we believe Germany, India, Japan, and the Eurozone would face the highest short-term risks from a continuation of the crisis, given their reliance on energy imports and on manufacturing performance.
Add to commodities, including oil and gold. Although oil prices would likely fall in the event of a resolution to the conflict, exposure to oil in a portfolio does provide an attractive diversifier to equity and bond exposure, since we believe oil prices could still rise much further if the Strait of Hormuz remains closed.
Meanwhile, gold has not performed well since the start of the conflict, with higher rate expectations and a stronger dollar weighing on sentiment. However, we believe gold could rally substantially should markets begin to focus on the negative growth impact of an extended period of high energy prices.
Replace some direct equity exposure with strategies that offer a degree of capital preservation. Volatility has risen through the conflict so far, though a VIX of 28 (at time of writing) is not stretched by historical standards. Furthermore, because interest rate expectations have risen, investors can still achieve potentially attractive terms on strategies that provide exposure to a degree of upside while preserving capital.
The current environment demands both discipline and agility. While the escalation in the US-Iran conflict raises the risk of prolonged energy supply disruption and heightened market volatility, history shows that markets can recover swiftly when geopolitical tensions ease. Our core advice remains: Stay strategically invested, but actively manage risk by diversifying, hedging, and reducing excess cyclical exposures.