investment insights
Iran-Israel, geopolitical risks and investing in an uncertain world
Key takeaways
- A world of rival blocs is redrawing supply chains, domestic capital spending, trade and investment flows, as well as driving indirect conflicts
- Developments in the Middle East are hard to predict. Our core scenario sees no major global escalation, but this possibility, and that of a de-escalation, are non-negligible
- Equities could suffer in any conflict escalation, and commodity prices and the dollar gain ground. Delayed central bank rate cuts could see sovereign yields fall. Conversely, a de-escalation could see riskier credit, equities and particularly cyclical sectors benefit
- We think our current positioning – a US dollar and developed market sovereign bond overweight, a strategic exposure to gold and a preference for US stocks and energy firms within our equity allocation – can perform in a range of outcomes.
Amid a stand-off between Israel and Iran, investors face a tense geopolitical backdrop, with many paths to conflict escalation. We examine the underlying risk drivers, potential scenarios, and investment implications.
The backdrop to escalations in the Middle East, the Russia-Ukraine war, and rising geopolitical tensions is a world divided into rival blocs. Today’s geopolitical framework pits a US-led axis against countries that do not accept US dominance, led by China, and those that are non-aligned. Arguably, factors such as the waning influence of multilateral institutions including the UN, World Bank and International Monetary Fund have played a role in rising instability, as have ‘push’ factors including widening wealth inequality, ageing populations, changing migration patterns and climate change straining resources.
Today’s ‘bloc logic’ leads to indirect conflicts and proxy wars. It drives economic de-risking to increase bloc-level resilience. Supply chains are being reconfigured towards ally countries; investment and trade flows are being redirected or cut. On balance, this tends to lead to fewer efficiencies and higher inflationary pressures compared to a peak globalisation era. Yet a world of flexing strategic muscles also means more capital spending to support domestic champions: tech firms in the US and China, but also broader industrial and healthcare players. A more antagonistic world is also leading to higher defence spending.
Iran’s attack on Israel, in retaliation for an attack on its embassy, and Israel’s subsequent strikes, have raised the geopolitical stakes. The attacks come amid high tensions elsewhere in the region, including the war in Gaza, disruption in the Red Sea, violence in the West Bank and Hezbollah attacks from Lebanon. Countries from across geopolitical divides are urging both sides to show restraint. Retaliatory attacks in turn could see an escalation by default. Risks remain elevated, with little sign that a tense regional power battle has been resolved.
The sheer number of possible scenarios is hard to forecast, and their interaction with other factors to drive market moves difficult to predict. Broadly speaking, we assess the probability of an escalation that drags in powers beyond the region at under 20%, roughly the same as a de-escalation that normalises relations. In other words, we think our baseline of ongoing proxy conflict reflects a subjective 60% probability.
Energy market and supply chain impacts
The key transmission channels for such risks are energy markets and supply chains. Iran supplies around 3% of the world’s oil, with terminals fringing the Persian Gulf and a fifth of global oil supply passing through the Strait of Hormuz on its doorstep. Risks include Israeli attacks on oil infrastructure, more stringent sanctions on Iranian oil, or disruptions by Iran in the Strait, which could see oil prices spike well over USD 100 a barrel. Trade risks include more disruptions in the Red Sea, or any escalation that affects the Suez Canal, a globally critical chokepoint for trade.
Yet our core scenario sees global conflict avoided and existing ‘bloc logic’ prevailing. The impact of geopolitics on global activity so far looks limited. Shipping prices may remain slightly elevated, but well below Covid spikes. In oil markets, and under our base case of no escalation, rising global demand, together with Russian supply disruptions and OPEC+ production cuts are likely to keep prices at the higher end of an USD 80-90/per barrel range. OPEC+ would likely use their spare capacity, equivalent to over 5% of global supply needs, to smooth out price disruptions. At these levels, and absent a major conflict escalation, we do not see oil prices disrupting our core scenario of a soft landing for the global economy, with gradually normalising inflation and a limited number of rate cuts ahead.
Nor is a tense geopolitical backdrop necessarily negative for markets; it was not during the Cold War. While the equity market run of the last five months has stalled, there has been no steep correction to date.
How should investors react?
Unsurprisingly, geopolitical uncertainty has not always coincided with market uncertainty, with key market drivers such as growth, inflation, and policy uncertainty often more important. Yet significant geopolitical risks have tended to raise market risks, in particular in recent years during the war in Ukraine and the Israel-Hamas conflict. Hence, the impact of geopolitical risks on markets needs to be analysed and integrated in our portfolio strategy.
Our geopolitical risk framework focusses on three scenarios – no escalation in the Middle East, a major escalation, and a de-escalation, and a de-escalation. So what is the market impact of each and what strategy should investors deploy to shield their portfolios? Firstly, we believe portfolio diversification is crucial to prepare for a wide variety of outcomes. Secondly, portfolio positions need to be managed actively, to take advantage of any dislocations.
Our current portfolio positioning is rooted in our base scenario of no major escalation of the conflict. In equities, we overweight US stocks at the expense of Europe, with a preference for cyclical stocks in the energy and consumer services sectors over defensives (real estate and utilities). In fixed income, we favour a US government bond overweight, and in currencies, the US dollar. These portfolio tilts continue to benefit from the US economy’s outperformance and the dollar’s yield advantage.
In a risk scenario of a major retaliation, we would expect equity markets to correct sharply, with defensive sectors such as real estate and utilities likely outperforming. Commodity prices, in particular energy, may spike and drive inflation expectations higher. Central banks would likely have to delay policy rate cuts, while the long end of government bond curves would normalise and yields fall on haven demand. This would flatten the yield curve, particularly in Europe, where the European Central Bank is more sensitive to commodity price increases. US Treasuries would probably gain ground. In credit, both investment grade and high yield segments would suffer, although we would expect the former to outperform the latter. In such a risk averse environment the US dollar would also likely benefit.
In a de-escalation scenario, we would expect our current positioning to benefit. However, with recent credit spread widening we would likely see a reversal providing some added impetus to riskier credit (such as high yield) and the more cyclical equity segments. Our preference for BB-rated debt within the high yield segment would likely benefit, even if some lower graded debt might temporarily outperform on the back of a stronger spread tightening. Still, we would prefer the higher quality segment of the high yield spectrum.
Positions that benefit from a range of outcomes
Overall, we think our current tactical positioning can benefit under a range of outcomes. In particular, we see our US dollar overweight, our constructive stance on gold – which we maintain at strategic levels – and our equity sector preference for energy firms, as not only being able to perform in our baseline scenario, but also as shielding portfolios in an environment of rising inflationary and geopolitical risks. Given these risks, we also see a potential role for Treasury Inflation Protected Securities (TIPS) within portfolios’ fixed income allocations.
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