The ongoing conflict in the Middle East has raised multiple concerns for South African investors. This article addresses some of their most pressing questions.
Should investors hedge explicitly against geopolitical risk, or is diversification enough?
Hedging geopolitical events explicitly is extremely difficult. First, you need to anticipate what may happen, and these events are notoriously difficult to foresee. Second, you need to judge when the specific event may happen, because carrying hedges for extended periods can be costly and erode returns. Third, you need to assess how the event will transmit to markets, with outcomes frequently differing from initial expectations. A well-diversified portfolio reduces the need for this kind of guesswork, and in our view remains the most reliable response in periods of elevated uncertainty.
In a protracted war, is gold still a good hedge?
We continue to view gold as a useful component within a diversified portfolio. Recently, it has traded more like a risk asset – rallying strongly (particularly from the second half of last year) before pulling back at the start of the current Middle East conflict. Strong price appreciation can attract speculative investors and trend-following traders who can drive the price too high, too quickly. While we reduced our gold exposure into the strong rally, we do believe the longer-term fundamentals remain supportive.
What could a prolonged war mean for commodities and global growth?
The Iran conflict quickly impacted energy prices and, as a result, global inflation expectations, driving global bond yields higher in March.
A second-order effect, and one we believe still hasn’t received sufficient attention, is the likely drag on growth. The full impact of the blockage in the Strait of Hormuz has been obscured by oil transport delays (up to six weeks for certain geographies) and drawdowns from both storage and strategic reserves. Oil shortages can lead to significant disruptions across supply chains, with oil and its derivatives inputs across a wide range of goods and services, well beyond transport fuels. In addition, higher energy prices divert consumer spending from other areas of the economy.
In a more extended conflict scenario, energy markets (oil and natural gas) could reprice materially higher. In contrast, commodities that are more sensitive to global growth may come under pressure.
How should investors position themselves for stagflation risk?
Even before the Iran conflict and the related energy spike, we believed markets were too complacent on inflation risk, and it seems likely that continued disruption in the Middle East will lead to growth prospects being revised downwards. As such, stagflationary risks to the global economy are likely to increase the longer the conflict continues.
Stagflation, which is typically characterised by slowing growth alongside elevated inflation, has occurred around 11% of the time since 1970. Historically, gold and commodities have tended to perform relatively well in such periods, while US equities (as proxied by the S&P 500 Index) and the US dollar have often lagged. Understanding that broad historical pattern is helpful when assessing portfolio risk. However, we believe starting valuations and earnings sensitivity under various potential environments are key drivers of share performance.
By John Gilchrist, Chief Investment Officer, PSG Asset Management