Use market bounce to diversify and hedge
CIO Daily Updates
From the studio
From the studio
Thought of the day
Thought of the day
What happened?
US stock and bond markets bounced and oil prices fell on Monday after President Donald Trump announced a five-day postponement of previously threatened military action against Iranian energy infrastructure, citing progress in discussions. This shift in tone was interpreted by markets as a step toward de-escalation in the conflict.
President Trump said in a social media post that the US and Iran had “very good and productive conversations” over the past two days. He later told reporters that the US was talking with a “top person” in Iran and had reached a “major point of agreement.” Iranian state news outlets denied that talks had taken place.
The S&P 500 rose 1.1% on Monday, Brent crude oil prices fell 10.6% to USD 100 per barrel, and gold pared heavy losses to trade about 3.6% lower at USD 4,411 per ounce. The 10-year Treasury yield, which had risen to around 4.44% earlier on Monday, fell to 4.35%, while the 2-year yield dropped to 3.85% from an intraday high of above 4%.
The developments demonstrate how quickly markets can turn on events. Earlier on Monday, equity markets in Asia fell sharply—the Kospi declined 6.5%, while the Nikkei 225 and Hang Seng indices were both down 3.5%—after President Trump had threatened over the weekend to “obliterate various power plants” if Iran did not “fully open, without threat” the Strait of Hormuz by 19:44 ET on 23 March. On Tuesday, Asia equities gained ground, with South Korea's Kospi up 2.7% and Japan's Topix rising 2.1%. The Euro Stoxx 50 index opened 0.5% lower and S&P 500 futures are down 0.2% at the time of writing on caution over how quickly hostilities are likely to end.
What do we think?
We believe Monday’s market gyrations validate our view that investors should not attempt to trade geopolitics and should maintain long-term equity holdings. Markets are forward-looking and can often trade not just on changing information but the rate of change in that information. So, a situation merely getting “less worse” can be sufficient for markets to bounce.
At the same time, the recent sequence of escalation, retaliation, and pause underscores that the path forward remains narrow and conditional. A failure of talks could quickly reverse recent market bounces. Renewed brinkmanship is probable, further strikes and disruptions to energy flows are likely, and future infrastructure destruction is possible. We note that TheWall Street Journal on Monday reported that thousands of US Marines are set to arrive in the region on Friday.
Investors should also be wary of assuming that the path to a restoration of energy flows will be smooth, even if talks prove successful. Shippers will need to develop the confidence that threats have been neutralized, which could be a slow process. Production that has been shut in could take time to bring back online. Meanwhile, oil product inventory levels are running low in various economies and could necessitate even higher prices to ration demand before stocks are refilled. Against this backdrop, it looks likely that energy prices will remain elevated for at least the near term, weighing on growth and driving episodic volatility.
In our CIO Alert on 9 March, we said that investors should take steps to progressively derisk portfolios the longer that oil prices remain high. We believe that the current market bounce provides investors an opportunity to review exposures to assets that are most sensitive to high energy prices.
What to do here?
Use the bounce to diversify excess exposure to at-risk equity markets, in favor of structural growth and defensive markets. Wh ile we retain an Attractive stance on equities overall and believe investors should retain long-term exposure to the asset class, we downgraded European, Eurozone, and Indian equities to Neutral. We also upgraded Swiss equities and the European health care sector to Attractive.
European equities are pro‑cyclical and sensitive to elevated oil and gas prices, as persistently high energy costs could undermine the manufacturing recovery. Elevated inflation and geopolitical uncertainty could also dampen European consumer sentiment, and uncertainty about potential European Central Bank (ECB) rate hikes could also weigh on investor sentiment, even though we do not expect them to ultimately materialize.
Meanwhile, India’s economy is highly sensitive to the price of oil, 88% of which is imported. While its energy supply chain is diversified, with imports from Russia and the US, 40% comes via the Strait of Hormuz. Along with crude, India is also heavily reliant on liquefied natural gas and liquefied petroleum gas from the Middle East. Higher energy prices look set to widen the current account deficit, add to fiscal pressures, and slow growth.
We see greater appeal in more defensive markets with secular growth and limited exposure to energy disruptions. Against this background, we upgraded Switzerland’s equity market and the European health care sector to Attractive. Both markets are down by more than 10% since the start of the conflict, despite typically being low beta (i.e., less volatile) markets, leaving valuations relatively appealing, in our view. Tariff and US drug pricing uncertainty weighed on both segments last year but is now largely behind us, and we believe the headwind to profits from a weak US dollar is coming to an end. Dividend yields for Switzerland (3.2%) and European health care (2.7%) also look interesting both for income-seeking investors and as a potential tool to steady portfolio returns.
Investors can also improve portfolio resilience by considering replacing direct equity exposure with exposure to strategies that offer a degree of capital preservation. A VIX of 26, at the time of writing, is not stretched by historical standards. And because interest rate expectations have risen since the start of the conflict, investors may still be able to achieve potentially attractive terms on strategies that provide exposure to future potential gains in a rebound, while preserving capital.
Add to short-duration quality bonds. Despite rallying on Monday, bond markets are still pricing close to three interest rate hikes by the ECB and two by the Bank of England this year and no cuts by the Federal Reserve. We believe bond markets are currently too focused on the short-term inflationary impact of higher energy prices and not enough on the potential medium-term negative growth impact that could drive interest rate cuts, nor on the potential for de-escalation.
This creates an opportunity for investors to “lock in” elevated short-term interest rate expectations across the USD, EUR, and GBP government bond curves out to 10 years. Our preference is for short-to-medium maturity quality bonds for global investors. For US investors, we see exposure to short-duration quality bonds as a potentially appealing way to earn attractive yields and to position for a potential decline in yields, either if markets begin to price a negative growth shock or if the conflict is resolved and short-term rate hike expectations are priced out. On Monday, we upgraded US Treasuries to Attractive with a focus on two- to five-year durations in our US asset preferences.
Add to commodities, including oil and gold. Oil prices fell sharply on Monday, offering a potentially attractive entry point for investors looking to build exposure to oil in a portfolio and to diversify equity and bond exposure. We think oil prices would likely rise again if mooted talks fail and the Strait of Hormuz remains closed, or if the process of restoring energy flows proves more protracted than hoped. Investors can gain exposure via funds, futures, options, or through structures.
Meanwhile, the gold price has fallen around 17% since the start of the conflict, with higher rate expectations weighing on sentiment. The stronger US dollar and reduced buying in the Middle East owing to supply chain issues have added to the pressure on gold, prompting profit-taking by some institutional investors and sovereign entities. However, over the medium term, we would still expect gold to rally substantially if geopolitical uncertainty remains high while interest rate expectations come down. We continue to view gold as an effective long-term portfolio hedge and forecast higher prices ahead. For those who favor gold, we suggest allocating a small portion—around a mid-single-digit percentage—of total assets to diversify portfolios and provide medium-term insulation from macro-related shocks.