Geopolitics is a constant threat to portfolios, however, incorporating these risks can pose asset allocation challenges for fund selectors.
The latest conflict in the Middle East combined with the ongoing war in Ukraine is creating a headache for developed market central banks and their 2% inflation targets.
Wars are inflationary, yet broad markets have not reacted to the Israel-Hamas conflict in any meaningful way so far apart from a small spike in oil and gold prices.
Analysis from the World Bank has warned a ‘large disruption’ scenario – which is comparable to the Arab oil embargo in 1973 – would result in as much as an eight million barrels per day supply reduction, sending oil prices up 75% to $157 a barrel.
Even in a ‘small disruption’ scenario oil prices could go as high as $102 a barrel which would send inflation – and subsequently interest rates – higher.
“Policymakers will need to be vigilant,” Indermit Gill, chief economist at the World Bank, warned. “If the conflict were to escalate, the global economy would face a dual energy shock for the first time in decades – not just from the war in Ukraine but also the Middle East.”
The risk of tensions escalating in the Middle East combined with a stronger-than-expected US economy is giving policymakers a headache.
After holding interest rates at 22-year highs on Wednesday, Fed chair Jerome Powell stated the US central bank is “prepared to adjust the stance of monetary policy as appropriate if risks emerge”.
Despite the warning, investors appear to be underestimating a commodity shock to the upside amid forecasts the Fed’s hiking cycle is over. According to the CME FedWatch Tool, there is a 29.7% chance of higher interest rates by January 2024 which falls to 24.2% in March.
Geopolitical and market uncertainty in this current environment make diversification the only free lunch for fund selectors.
An energy sector ETF such as the Xtrackers MSCI World Energy UCITS ETF (XDW0), which offers exposure to 57 companies set to benefit from a spike in oil prices, would play an important role in any multi-asset portfolio in this scenario.
Elsewhere, investors can access oil prices directly through the WisdomTree Brent Crude Oil ETC (BRNT) which tracks a basket of Brent Crude futures contracts that are continuously rolled on a set schedule.
While the effects of geopolitics on markets tend to be short-lived, if the Israel-Hamas war escalates, a global oil supply shock will reinforce the ‘higher for longer’ narrative, a boon for short-dated US Treasuries and commodities.