Middle-East Conflict: implications for our Clients

2020 has just started and already geopolitics is front and centre. The conflict between the US and Iran has escalated after the recent elimination of the top Iranian military master mind. Iran has vowed to retaliate, upon which president Trump has promised to strike back if Iran would carry through its menace. So far, the response from Iran’s allies – Russia and China – has been fairly muted but it remains one to watch.

The impact on markets has been fairly classic with falling equity markets, higher oil prices, and better performance from safe-haven assets such as gold and the Japanese yen. But what is really at stake?

• Iran has a lot of influence in Iraq as over 60% of the population is Shia (like Iran) and sympathises with Iran. Iraq is the second biggest oil producer within OPEC with around 4.5m barrels per day. The most important oil fields are in the south, i.e. Shia territory. If these fields were to shut down, then oil prices would spike higher. The most likely result of the current situation is that the risk premium embedded in the oil price will increase for longer.


• Calling the level of the oil price is always tricky. Were the Brent price to rise structurally above 70$ per barrel, then US shale oil producers might start to produce more and/or hedge future production, i.e. sell forward. That should limit the upside potential.


• Hence, even if the situation is precarious and should be monitored, higher oil prices could be positive for US High Yield bonds as a large part of that market is linked to the US energy sector.


• This backdrop is less positive for oil importing countries and especially the Emerging Markets countries with fragile current accounts. India and Turkey are good examples and like in the past their currencies and bond spreads could suffer.


• Volatility is likely to rise. Overall, volatility levels for all asset classes have been extremely low and from those levels it can only rise if tensions escalate further in the Gulf region.


• The upshot from this is that risky assets could lose somewhat while safe-haven assets are to benefit.


• Gold, the Japan yen and Government Bonds are examples of safe haven assets that could benefit.


 

We do not recommend making changes ahead of events where the outcome is highly uncertain. Instead we maintain a holistic approach by keeping our client portfolios diversified. In our current asset allocation, we are neutral on equities and thus do not carry excessive amounts of risk. In fixed income, while our government bond exposure remains low, we increased it in the fourth quarter by adding to U.S. Treasuries. We also maintain our positive view on the Yen as a safe-haven asset. Moreover, gold remains a strong conviction and has been well represented in portfolios in the last 12 months. In fact, we believe that with bond yield levels already very low, gold might increasingly become the defensive play of choice in investors’ portfolios. While inflation might rise on the back of higher energy prices, central banks look to be in no hurry to hike interest rates. Gold should remain well supported.

Therefore we will keep a close eye on the situation in the Middle-East, and our current asset allocation will remain unchanged.

Brown Shipley Investment Office

 

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