• The conflict has pushed oil prices sharply higher, as investors fret about higher energy costs feeding through into inflation while simultaneously weakening growth.
• Equity and bond markets have sold off globally as a result, and interest rate expectations have changed materially.
• Strong performance early this year and diversification have helped cushion the drawdown, with global value aiding resilience and infrastructure/commodities being considered as further hedges.

Markets have been rattled by the outbreak of war between Israel, the US and Iran. Crude oil prices have risen by roughly 55% over the past month¹, reviving fears of a fresh inflation shock just as investors had become more comfortable with the disinflation story. Stock markets are down across the board. The US stock market has proved relatively resilient, down 2.7%, supported by safe haven demand for the dollar and America’s relative energy independence. The FTSE 100 has fallen by 5.5%, and Germany and Japan have experienced drawdowns of more than 7%, reflecting their greater vulnerability to higher energy costs.²

The more striking move has come in bond markets. UK gilts have been hit particularly hard, with yields rising from just above 4% to over 4.7%, a much sharper repricing than in other major economies³. Bond investors are clearly worried about what sustained higher energy prices would mean for UK inflation, growth and the path of interest rates.

If lower oil output and disruption through the Strait of Hormuz persists, the result is not just higher inflation, but weaker growth at the same time, a particularly nasty phenomenon known as stagflation. Markets have already begun to reprice rate expectations, with fewer cuts now expected in the UK and Europe than were being priced only weeks ago⁴. Indeed, the swaps market implies that rates will climb in Europe⁵.

The key question for investors is how long the situation will last. If the war drags on for months, the risk grows that inflation stops being a temporary shock and becomes more deeply embedded, adding potentially as much as 1% to inflation⁶. That would weigh on GDP growth and make it much harder for central banks to cut rates. If it proves shorter lived, history suggests markets can recover relatively quickly.

There are some reasons to think the conflict may not be overly protracted, despite hostilities showing no sign of easing. US officials have struck a tone that suggests they want a conclusion sooner rather than later⁷, and there have been reports that Iran may be looking for an off-ramp privately, even while remaining belligerent in public⁸. Iran has already suffered significant military and infrastructure damage, but its objective now is likely to be imposing the maximum possible economic pain. In practical terms, even the threat of disruption in the Strait of Hormuz can be enough to choke off shipping flows and unsettle markets.

Higher prices tend to focus minds on resolution, whether through de-escalation, increased output elsewhere, sanctions relief, or the release of strategic reserves. The chart below is a useful reminder that while markets often tumble in the days and weeks after geopolitical shocks, returns have historically improved over longer periods.

Ultimately, there is still a lot up in the air and it is impossible to know exactly where things land, or when. What matters is staying diversified, avoiding knee-jerk decisions and keeping a close eye on developments. News is changing by the hour, sentiment is swinging with every headline, and price action has been extreme. Extreme volatility can punish investors very quickly if they are trying to trade the news rather than stay disciplined.

Owing to a strong start to the year, the resulting pull back in your investment portfolios since the end of February has been limited to the gains we have seen this year, and our positioning remains diversified across asset classes, geographies and styles. Recent moves to add global value have also been helpful, as that typically brings greater exposure to energy producers, which can benefit when oil prices rise. We are also looking at infrastructure exposure as a potential hedge should inflation prove stickier and the conflict take longer to resolve. We will continue to watch markets and news flow closely as events develop.

The value of your investments can go down as well as up, so you could get back less than you invested. Past performance is not a guide to future performance.

Sources:
1. Trading Economics
2. Trading Economics
3. Trading Economics
4. Global Banking and Finance Review
5. Bloomberg News
6. Office for Budgetary Responsibility
7. ABC News
8. Le Monde