Rising Tensions

With a promise to continue the effort for “as many days as it takes,” Israel launched air strikes against Iran’s nuclear and military facilities. So far, the attacks have resulted in the deaths of prominent military leaders, like the heads of both its armed forces and the Revolutionary guards, as well as nuclear scientists. The U.S. has stated that Israel acted unilaterally. However, President Trump has again warned Iran to make a deal with Israel quickly. 

One of the major concerns at this point centers around the impact these events may have on the oil market — both directly on Iranian supply and also in any potential disruption in the Strait of Hormuz, through which over 25% of the world’s oil passes. While we see most risk assets selling off in the wake of the attack, global crude markets are catching a bid, with oil prices rising nearly 8% to over $70 per barrel. The nearly 25% fall in energy prices since last July has been a disinflationary tailwind and has contributed to the improvement we have seen in overall inflation in the U.S. With higher oil prices, however, the risk is that this tailwind becomes a headwind. And with the additional threat of higher tariffs also potentially driving inflation higher — at least near term — this is an unwelcome change, threatening to further complicate the Federal Reserve’s monetary policy path.

It is tempting to try to time markets around geopolitical events: Rising tensions could drive a potentially prolonged period of uncertainty and could perhaps drive an equally long period of negative returns across risk assets. The historical data contradicts this intuition, however. Unfortunately, we have dozens of examples of rising geopolitical tensions, financial crises and events that evolved into wars. When looking at “market shock” events going back to the German invasion of France in 1940, we observe that, on average, markets have typically been higher three, six and 12 months later. Of course, there are exceptions to the rule: The S&P was still in the red 12 months after the Russian invasion of Ukraine, and it was down steeply even a year after the collapse of Lehman Brothers in 2008, so the scorecard would suggest that it is extremely difficult to tactically shift portfolios around major shocks. However, it is clear that what has ultimately mattered to investors have been the economic consequences of the event: For example, will the shock manifest in higher-for-longer inflation?  Will it have a real impact on economic growth?  Will it be met with a shift in monetary or fiscal policy? Those are the elements that tend to have a more persistent impact on financial markets.

Our advice remains to stay the course and maintain strategic- and goal-aligned asset allocations. Recognize that each event is unique. The current conflict between Iran and Israel may deepen and be prolonged, and we can and should anticipate more volatility as a result — but this is not a time to make major adjustments to portfolios.  

Our investment policy committee (IPC) met this week to review our base case, and the major change was a decline in the probability we had assigned to a U.S. recession. We had a 60% probability embedded in last month’s forecast, but with alleviating trade tensions and a heightened possibility of trade deals over the coming month, we are more confident that the U.S. economy can avoid a recession — still, the odds remain a bit of a coin toss. The good news is that, if we do have a recession, it will likely be short and shallow — similar to 2001, when the U.S. economy contracted by 0.3% from peak to trough over the course of eight months.

The U.S. economy is entering the current phase of uncertainty from a position of relative strength, and we remain convinced that inflationary pressures stemming from increased tariffs will not be persistent. This will give the Fed the opportunity to lower the policy rate to address any economic slowdown. However, the uncertainty around the inflationary impact of tariffs will prevent the Fed from acting pre-emptively.

We will hear more from the Fed next week during their scheduled June meeting, and while there is effectively a zero market-based probability assigned to a cut in the policy rate, investors will have plenty to digest. The June meeting is another time for the Fed to update the Summary of Economic Projections — a set of forecasts for growth, inflation and monetary policy. While the level of uncertainty remains high, we do not anticipate any major changes to the outlook.

Being globally invested and avoiding the home bias impulse has paid off for U.S. investors this year. Non-U.S. developed and emerging markets have outperformed, aided by notable dollar weakness. Investments in real assets and infrastructure have provided performance and diversification benefits, with real assets rising amid this week’s geopolitical uncertainty. Global infrastructure has proved resilient to bouts of overall uncertainty, with benchmark performance nearing 10% year-to-date. In our IPC discussions, we affirmed our commitment to a multi-asset-class risk asset portfolio — one that provides exposure to global equities along with meaningful allocations to real assets and infrastructure.

Much of the uncertainty we are dealing with today revolves around the unpredictability of the inflation outlook, and it is pragmatic that investors hedge that risk, which can be done most directly and effectively by owning TIPS. That said, in any environment, it is pragmatic to protect portfolios against inflation: Investors fund goals with after-inflation dollars, so protecting purchasing power is paramount. We affirmed our recommendation for investors to include Treasury Inflation Protected Securities (TIPS) in risk-control portfolios of high-quality bonds and cash.