Weekly Digest: Building in uncertainty

In uncertain times, humans tend to fill knowledge gaps with worst-case scenarios. That’s the conclusion of a study referenced in a recent Financial Times article. Even though the piece was talking about uncertainty in the workplace, the psychology could equally apply to worldviews and how they affect our attitudes to investing.

The situation in Iran is already deep into the Donald Rumsfeld territory of ‘knowns’ and ‘unknowns’ – the ‘fog of war’ metaphor is as apt as ever. But there are still plenty of facts that we can work with. And our investment process is built to handle situations such as this.  

Taking stock

As the war with Iran runs into its third week financial markets, on the surface, are showing a commendable degree of equanimity in the face of alarming headlines. As of Monday’s close, the MSCI All-Countries World Index was around 5% off its all-time closing high on 26 February. Last week’s divergence in performance between different regions and sectors was much less pronounced than in the first week of hostilities. A lot of the speculative and leveraged traders (those using borrowed funds) were flushed out pretty quickly. Last week the S&P 500 fell 1. 6%, for example, while the 2.0% loss for the MSCI World ex-US was not a lot worse.

Even so, the US has benefitted from some relative advantages, not least its position as a net exporter of oil and gas. That has been reflected in a decent rally for the dollar, with the DXY trade-weighted dollar index up close to 3% since the outbreak of hostilities.

The dollar has strengthened amid the war

The case for diversification

Sterling is down from $1.35 to $1.33, but it’s the euro that has taken the biggest hit, falling from €1.18 to €1.15 per dollar. For non-US-based global equity investors, that will have provided a nice cushion of higher returns when translated back to the home currency. And the high proportion of dollar revenues for UK large caps will also have helped. This underlines the benefits of global diversification. It also provides some justification for our reluctance to put currency hedges on non-sterling equities and other so-called risk assets. That is, unless we have a very specific reason to (such as a policy to devalue the currency in question as was effectively the case with the yen in the era of ‘Abenomics’).

What about other diversifiers that we hold alongside these risk assets? The challenge when choosing your insurance is that you have to know what you are insuring against. The dollar’s fall after last year's ‘liberation day’ tariffs created havoc in terms of portfolio volatility. This time the dollar has risen. Given what happened in 2025, that has probably caught a fair few traders off balance.

A market troubled by a new inflationary threat is not a good environment for bonds. The Bloomberg Global Aggregate Index of investment-grade (higher credit quality) bonds has fallen 3% this month. With bonds continuing to move in tandem with equities, they’re providing no diversification benefit.

This throws the concept of a 60:40 equity/bond portfolio up in the air or even out of the window. This was the ‘go to’ strategy for many investors for the two decades up to 2021, a period when equities and bonds tended to move in opposite directions, which dampened portfolio volatility and boosted risk-adjusted returns.

The demise of this ‘sure thing’ emphasises why we put such effort into selecting the right components of the 'diversifiers' bucket in balanced portfolios. It’s not clear to me that the penny has dropped with everyone in the industry yet, with ‘lifestyle’ type pension funds still pushing investors deeper into the bond market the closer they get to retirement. If one is going to own bonds in this environment of higher inflation and greater volatility, we believe the best strategy is to stick with those with a shorter time to maturity. Of course, there can be tactical opportunities to increase duration and that is always under consideration.

A world of higher inflation

The correlation ‘regime shift’ that has been in place since 2021 is driven by inflation. Core US inflation (excluding the more volatile items of food and energy) of 2% seems to be the tipping point. And we are stuck above that level at the moment, having been largely below it for the previous two decades. It might well be that we fall below it again in the future if the promises (or threats) of AI materialise, but it’s definitely off the agenda for now.

There are plenty of factors that feed into structurally higher inflation (and inflation volatility). These include domestic politics (with a bias towards more populist policies), geopolitics (with the current situation being an obvious example), climate change, and the energy transition. And all with a potential side order of demographic shifts (although economists differ on whether ageing populations will be inflationary or deflationary).

More encouragingly, recent events have not led to an especially sharp rise in inflation expectations among investors. That speaks to two possibilities: either market participants think central banks will lean aggressively against an inflation shock from higher energy prices (e.g. by raising interest rates); or that the war will be concluded relatively swiftly with supplies restored. The latter outcome would obviously be – by far – the preferable one for investors.

Looking for the exit

Are we any closer to divining the outcome on the war and thus being able to take a more positive directional view? The biggest surprise over the past couple of weeks, including for the US government it seems, has been the scale of Iran’s response to the attacks. The various Middle East experts I have either heard speaking or read generally conclude that the existing regime, as long as it feels threatened, will continue its current path of action. That does not bode well given the latest comments from the US and Israel suggesting a continuation of the current regime would be unacceptable.

That opens up the risk (though a low-probability one) that, as long as the war continues, things could suddenly get worse very fast. This mainly pertains to energy supplies as well as to other key commodities. We are already in a situation where oil production is having to be curtailed owing to the lack of storage facilities. And it’s not just a case of flicking a switch and getting supplies up and running again when the situation allows. There is also the risk that more infrastructure is going to be damaged, meaning that production and refining capabilities are offline for longer. 

And yet we know that there are a lot of parties that would like to see this war end quickly, not least because of the risk of an energy-price shock. And the clock is ticking on US mid-term elections, for which Trump needs to manufacture better news. The 30% increase in petrol prices so far is not doing the Republicans many favours. 
 

US voters face rising prices at the pump

All of this makes it impossible to build portfolios based on any highly probable outcome. Somehow, we need to adopt enough safety measures to cushion the impact of a potential escalation while still being able to benefit from an early resolution. As ever, the longer the investment horizon, the easier it can be to ride out short-term volatility. That’s why, in the majority of cases, we recommend remaining fully invested but in an appropriately balanced manner.