Weekly Digest: Keep your seatbelts fastened

I started last week’s commentary by noting the numerous forces at work in the markets, beyond the conflict in the Middle East, and tried to convey a sense of the bigger picture that long-term investors need to be mindful of. One week on, and investors’ immediate focus continues to be on the Iran conflict and related market convulsions.  And rightly so – we understand our clients’ concerns about the implications for their portfolios of the escalating conflict.

While we remain vigilant as the situation develops, we still believe that it’s best to stick to long-term strategies. That’s still preferable to trying to trade on the unpredictable twists and turns of this war. 

Underestimating Iran’s reaction

As the first week of hostilities unfolded, it became clear that the wider investment community (and possibly the US government) had underestimated the scale of Iran’s reaction. The consequences included, most strikingly of all, the effective closure of the Strait of Hormuz because of Iranian attacks on shipping. Before the conflict, about 20% of the world’s oil passed through the Strait.

The cost of a barrel of Brent crude oil rose from $70 on the eve of the attacks to an intra-day peak of close to $120 on Monday, 9 March. Stocks also fell.

But when markets closed on Monday, they’d bounced back from the initial steep selling that started the week. Major regional equity markets were between 2% and 10% lower from when the crisis started. That’s left global equity indices, in aggregate, back where they started, although the UK’s FTSE 100 has delivered a total return (including reinvested dividends) of 5.3% (see chart below).

Stocks are mostly little changed or up for the year so far

Yields on longer-dated government bonds have risen again as inflation, through higher oil prices, becomes a bigger threat, delivering capital losses to holders.

A balanced sterling-denominated portfolio, however, is roughly flat for the year so far.

The greatest impact has been on commodities, especially energy, with the world focused on the Strait of Hormuz, the narrow body of water between Iran and Oman. The key question is how long the flow of energy through the Strait will be affected. This will determine how large any potential stagflationary shock might be. By that, we mean a shock that pushes up inflation and pushes down growth.

Natural gas prices will be of more concern to importers, including the UK and Europe. UK wholesale gas prices had doubled from £80 per thousand therms (one therm = 1,000 British thermal units) per day to £160, before falling back somewhat.  And gas is the marginal price-setter for UK electricity prices. At least the blow is softened in the short term by the fact that household utility prices are now set until July. The government may also reintroduce subsidies to cap them in future.

Moreover, supply disruptions don’t just affect household energy. UK farmers are already suffering from flooded fields and crops have also been disrupted by extreme weather in Southern Europe and North Africa. So these supply disruptions will make it more likely that fresh food prices rise too.

And taking a wider view, many countries on the Asian sub-continent, notably India, count on fertiliser supplies from the Middle East. Shortages could unleash a humanitarian crisis.

Light at the end of the tunnel?

Since Monday’s dramatic moves, there’s been better news and a more positive market response. The International Energy Agency (IEA) has proposed releasing 400 million barrels of oil from strategic reserves, the largest in the IEA’s history (see chart below). This is more than double the agency’s biggest prior release. It’s also the equivalent of about a month’s worth of the reduced supply from the Middle East, taking into account the fact that the Saudis are diverting as much oil production as they can to the Red Sea via pipelines, avoiding the Strait of Hormuz.

Historic and proposed releases of IEA's strategic oil reserves

The need to keep supplies flowing was emphasised by US plans to provide naval escorts through the Strait. France has also offered to send destroyers to the region to keep shipping lanes open. In addition, the US plans to offer a government-backed reinsurance facility for tanker owners. But markets responded most positively to comments by US President Donald Trump on Monday evening, suggesting that he saw the end of hostilities approaching.

Brent crude front-month futures (contracts to purchase Brent crude with the nearest expiry – the most actively traded price for crude), have settled to around $88 per barrel at the time of writing. That’s down from an intra-day high close to $120 on Monday. US equity markets, which had at one stage early on Monday been priced in for a 2.5% fall in futures markets, ended the day gaining almost 1% and were roughly unchanged from there by Tuesday’s close. You can read more about  the context of these moves in our recent Investment Update.
 

What action to take?

Since Monday’s dramatic moves, there’s been better news and a more positive market response. The International Energy Agency (IEA) has proposed releasing 400 million barrels of oil from strategic reserves, the largest in the IEA’s history (see chart below). This is more than double the agency’s biggest prior release. It’s also the equivalent of about a month’s worth of the reduced supply from the Middle East, taking into account the fact that the Saudis are diverting as much oil production as they can to the Red Sea via pipelines, avoiding the Strait of Hormuz.   

There are two factors at work here. One is a rotation into the companies that produce real stuff and not intangible intellectual property. Some of this is down to the lower likelihood of their products or services being disrupted by AI. Sectors such as Healthcare (9.5%) and Consumer Staples (13.3%) were often largely ‘under owned’ by active managers and there has been a rebalancing of positions.  

But the bigger winners have been companies benefiting from the AI-related capital expenditure and also the willingness of many governments to dial up spending on things like defence and infrastructure. The global materials sector has risen 23.9% with industrials up 13.5%. And don’t forget geopolitical tension, which has put a bid under the price of oil again. The energy sector is up 21%.

New investment money has also been favouring non-US markets rather than being attracted to the large cap US magnet as it has been for several years. This is partly down to the more favourable sector exposure outside the US. There has also been a bit of buyers’ strike on US financial assets in the current political climate, although we have not seen a headlong exit. The wheels of asset allocation tend to turn very slowly for large US institutions such as pension funds and endowments, and they really haven’t had to contemplate this sort of situation for many years. Home bias had paid off. Not so much now. It would be reasonable to expect more allocations to head abroad from the US.

It might not be reasonable to expect similar returns to be repeated over the next few months, but the aphorism that “the only free lunch in investing is diversification” seems to be holding true again. We try never to ‘bet the farm’ on narrow outcomes. Sometimes, that can mean lagging the most positive returns, but it provides a lot of comfort in more testing times.

Staying invested

Of course we remain prepared for further disruption and volatility in the short term. But the fact that the US administration has set a changing, and sometimes contradictory, list of objectives for success means it has given itself choices. It can decide what success is – and de-escalate when it asserts that success has been achieved. As we’ve witnessed with other decisions from Trump, this could happen at any moment – and there would be no time for investors to react.

Sticking with long-term strategies and well-constructed portfolios remains the best way to keep our seatbelts fastened through the current turbulence.