A new escalation between Iran and Israel
The escalation in the Middle East took a new turn yesterday as Iran fired a barrage of ballistic missiles at Israel in retaliation for the start of ground operations in Lebanon. At the time of writing, it’s too early to tell whether the conflict could broaden to the wider region and/or involve the US – where things are further complicated by the presidential election in November.
This attack nevertheless marks an escalation in the conflict and seems different from the specific operations from both parties in April. This puts geopolitical risks back to the forefront of investors’ minds. While still unpredictable, we might face heightened and protracted geopolitical tensions over the coming days or weeks, or phases of escalation and de-escalation. Either way, market volatility could rise further.
Markets fly to safety, and oil rises
As a result of Iran’s attack on Israel, investors rushed to buy safe-haven assets (those which tend to appreciate when sentiment deteriorates) and commodities. Gold rose 1%, the US dollar strengthened, and so did US Treasury prices (and yields fell). The Swiss franc, another defensive currency, also appreciated against the euro. Oil prices, which benefit from tensions in the Middle East, rose 2.5%. We see upside risks to oil prices, as Iran is an oil producer. Meanwhile, equities fell across the board, with the S&P 500 down 1%. Volatility indices spiked, too.
For now, it doesn’t look like a major sell-off (nor a significant spike in oil prices), but market direction and confidence will likely depend on whether there’s a further escalation. Chinese markets, which rose sharply last week on Beijing’s stimulus, are closed until 7 October due to the Golden Week.
How we continue to navigate market volatility
One of our central themes for 2024 and beyond is a more ‘fragmented world’ along geopolitical lines. The thesis is that geopolitical actors with contrasting goals can spur market volatility. At the end of 2023, we bought assets that could protect from geopolitical risks (and inflation risks), such as commodities, which we added on top of our long-standing gold exposure. Earlier this year, just before the start of the bout of Middle Eastern tensions in April, we bought an ‘insurance’ instrument in portfolios where client knowledge and regulation permit. The instrument appreciates when equities are falling, partially protecting portfolios from market sell-offs. We still hold this instrument, and so far, it has helped in periods of market stress.
Our multi-asset and globally diversified strategy aims to mitigate the impact of local events by gaining exposure to regions and asset classes that are driven by other factors. We remain confident with our positioning in the face of volatility and take comfort that our year-to-date performance has proved resilient. However, we’ll continue to monitor the situation closely and stand ready to adjust as appropriate.
Central bank rate cuts should offer market support
Government bonds and other high-quality fixed income assets have performed well recently, as central banks have started to cut interest rates. Our short-dated government bond overweight is likely to benefit if central banks were to lower rates further to support economic growth. In addition to reacting to falling inflation, the US Federal Reserve (Fed) also cut rates to support its weakening labour market. So, in the event of growth slowing further due to a worsening situation in the Middle East and a spike in oil prices which could weigh on growth, the Fed could cut rates more aggressively, which would cushion the market impact.
The impact on inflation could also be limited. The US produces far more oil than Iran – the US accounts for around 20% of global oil production compared to Iran’s 4% – and therefore, the risk of a sustained spike in oil prices is relatively limited. The European Central Bank and the Bank of England, similarly, have room to cut rates more aggressively if warranted. We believe the risk of a resurgence of inflation as we’ve seen during the pandemic is limited at this stage: back then, supply was disrupted globally, demand very strong and fiscal stimulus ample; now, supply is functioning much better (though it might be disrupted in parts of the Middle East), demand is weaker and fiscal stimulus, in many regions, is no longer there.
Data as of 02/10/2024.
