How should investors deal with risk of war?

By hedging for one risk (war), investors could end up overexposing themselves to a plethora of other risks.

Investors by now should be no stranger to global political instability having an impact on their portfolio. Throughout the 2010s, investors have had to navigate the eurozone crisis, the Brexit vote and now the unfolding US/China trade war, which has seemingly spilled into a broader confrontation between the two economic superpowers.

Following the assassination of Iranian general Qasem Soleimani, investors were confronted with a new geopolitical risk to their portfolio: the potential of a destructive war between the United States and Iran. While that risk, at least for the time being (as at time of writing on 9 January), appears to have sharply receded, the event has some valuable lessons for how investors should react to the prospect of war.  

Broadly, the market reacted negatively to news of Soleimani’s killing, with markets fearing the damage to the global economy such a war would bring about. Iran’s response, the bombing of military bases used by US troops in Iraq, saw a repeat of this. Certain financial assets, however, rallied on the back of both events, including so-called safe havens such as 10-year US government bonds and gold, and those set to directly benefit from a conflict such as oil and defence sector stocks.

Donald Maxwell-Scott, an investment manager at Rowan Dartington, pointed out after the events: “The only risers in the FTSE 100, as at 6 January, were Royal Dutch Shell and BAE Systems. It is easy to see why BAE systems might also be on the rise. With escalating tensions there may well be an increase in defence contracts in the region. The rest of the market, however, appears to be deep in the bunker, as investors worry about the potential consequences of a new conflict in the Middle East.”

What should investors have done? While it is easy to say with hindsight, very little. As Maxwell-Scott noted at the time: “The simple message we would have for investors at this time is not to panic. By reading the newspapers, it might appear that the US is on the brink of an apocalyptic war with Iran; however, the more likely scenario is that both sides are far from it.

“Of course, the markets were in negative territory (earlier this week) because they do have to price in the uncertainly of how events will play out over the coming weeks/months.”

Some investors, however, may have been tempted to react by positioning their portfolio to benefit in the event of war/further escalation. Famed stockpicker and former hedge fund manager Jim Cramer floated the idea of a “war time asset allocation”, on his CNBC show Mad Money. “If you think a genuine war with Iran is inevitable, you want cash, you want gold, utilities, oil, defence and cybersecurity.”

It is easy enough to see the logic here: gold goes up in times uncertainty; utilities are a defensive play; war would restrict the supply of oil, sending up the price of a barrel; defence companies and cyber security companies would see increased business in a US/Iran war. Cramer also suggested a high cash allocation in order to take advantage of buying opportunities.

But was this sage advice for investors? Many of the assets suggested did enjoy strong rallies on the back of the initial news of Soleimani’s killing.

The follow-up attack by Iran also saw markets react in much the same way. As Mihir Kapadia, the CEO of Sun Global Investments, summarised the morning after the attack (8 January): “Investors have turned away from stock markets on Wednesday and instead put their money into the usual safe haven commodities.”

Already priced in

Private investors, however, should have been wary about jumping into these assets with the expectation that they will continue to go up.

The market is a voting machine, with prices (in theory) reflecting all known information by the thousands of market participants. On that basis the market has readjusted the share price of, for example, Lockheed Martin, given the likelihood of escalation/war based on all known information.

Investors choosing to pile in after the event would essentially be saying markets have underpriced the risk of war.

That’s a dicey game for investors to play. Foreign policy decisions are never easy to predict – even more so with US President Donald Trump, who has already proved himself to be unpredictable, at the head of the table.

Indeed, at the time of writing, there is a general consensus the strikes from Iran were part of an attempt to de-escalate while “saving face”.

As a result, markets have gone back up, with the S&P 500 reaching a new high. Meanwhile, the price of oil has receded to below $60 a barrel, gold is slightly down from its war fear peaks alongside key defence sector stocks. Lockheed Martin is down 1.7% from its peak, while BAE Systems is down around 1%. Anyone buying into these assets as part of a “war time allocation”, depending on the price they bought in at, is likely slightly down.

Again, the market could be wrong here. The US could end up responding to Iran with greater force than anticipated, again ramping up the possibility of war. But the point is that attempting to forecast such events is something long-term investors should generally avoid given the unpredictable nature of geopolitics in the short term. By taking such a bold move against the market on such an unknowable outcome, investors are exposing themselves to substantial risk.

More going on in the world

Investors tilting their portfolios towards assets supposedly set to gain in the event of war should also remember that the current tensions between Iran and the US are not the only factor shaping markets. War may be leading the headlines, but it is far from the only thing being reflecting in asset prices. 

Take gold. While gold went up on the back of the news of Soleimani’s death, gold’s current price is a reflection of wider market sentiments such as increased inflation expectations. As Ned Naylor-Leyland, manager of the Merian Gold & Silver fund, pointed out: “The rising gold price is therefore more a reflection of the possibility of lower real yields than a rising ‘war risk’.”

Also driving gold prices is historically large purchases by central banks and a consolidation of suppliers, leading to expectations of more restricted supply in the future. Should any of that change, or at least the market’s interpretation, so too could the price of gold.

It is a similar story for bonds. Those loading up on more bonds on the belief that will act as a safe haven asset in the event of further tensions are exposing themselves to new risks – chiefly duration risk. Investors in bonds now face the risk that bond prices will sharply reverse when/if central banks ever start to raise rates again. A reversal in monetary policy from the world’s major central banks does appear unlikely, but is still entirely within the realms of possibility. By hedging for one risk (war), investors could end up overexposing themselves to a plethora of other risks.

Diversify diversify diversify

What the skirmish between the US and Iran showed, however, is the importance of having a well-diversified asset allocation to begin with. Investors should already have a diversified portfolio that includes some holdings that benefit in such a scenario such as energy stocks, bonds and arguably gold. If the risk of a serious war looms, the gains from that part of the portfolio should offset some of the pain from a broader fall in equity markets. But attempting to chase the news and go into such assets after the risk appears will likely just see the investor pay higher prices where the risk is already “priced in”.

Added to that, a good rebalancing strategy, in theory, should help to see investors benefit from the associated volatility. After all, assuming the storm will pass (for financial markets at least), the smart investor will probably want to be on the other side of sentiment driven trading, rebalancing into punished assets and taking profits on those that have been bid up.

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I agree, over reacting to…

I agree, over reacting to any single issue or indiactaor will just open investors up to other risks. The alternative is to get stuck in a cat and mouse game where by you constantly shifting from "the next big risk" or the "best allocation" right now, and history would suggest trying to predict markets on that level is always a losing strategy.

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