This week’s blog is written by portfolio manager, Sacha Chorley.
One of the challenging things about investing is how financial markets almost pre-condition us to want to take some kind of action. Some of this can be self-inflicted: we must have the self-discipline to not get fixated on the flashing numbers on a Bloomberg screen or the latest marginal change to an economic data series.
The added difficulty is that when things are changing in potentially large and significant ways, the draw of doing something also gets larger. A clear example of this is the developments in the Middle East, with the rocket and drone attacks between Israel and Iran over the last week.
With any kind of military activity there is the risk of escalation. The region clearly has meaningful trade flow in terms of energy products – around 30% of the world’s crude oil is produced in the Middle East and around 20% of all petroleum products pass through the Iranian-controlled Strait of Hormuz. Any disruption to oil supply would cause immediate inflationary pressures as oil prices spike, but if oil prices remained elevated this could well end up with downward pressure on growth. Another complication is the Iranian regime’s increased production of highly enriched uranium, which is used in nuclear weaponry. This increases the likelihood of US military intervention, which could then further escalate tensions.
Although it is very easy to see a situation as worse than it is and lean towards derisking portfolios, it is worth examining historical patterns to see whether this is a good course of action or not. Some work by researchers at Deutsche Bank found that in 32 geopolitically driven market falls since the 1940s, the median fall in the US equities was 6% over a period of 17-working days with the fastest fall occurring in just two days. Given this sample includes only those events that led to a fall, it is interesting to note that this level of the fall is consistent with the natural level of volatility you would expect from owning equities anyway. Contrary to the perception that geopolitical issues end up causing structural shifts, this study showed that the median recovery took only 16 days.
A better way to manage these kinds of events is to ensure that portfolios are diversified to manage risk in a range of different market environments. It’s not possible to predict whether a specific geopolitical event may or may not occur, but ensuring a portfolio is built to be all-weather is very achievable. Indeed, a benefit of multi-asset investing is that this is baked into the portfolio construction process as the core asset classes of equities and bonds inherently provide exposure to different risk factors. We can add to this through alternatives positions like ‘trend following’ or macro strategies that are uncorrelated to equities. Similarly, having explicit protection strategies such as equity ‘put’ options, which function as a kind of insurance policy on the stock market, can further provide downside defence in times of stress.
Ultimately, constructing portfolios with these tools gives you the freedom to choose to do nothing. That breathing space allows for more thoughtful decision-making, reducing the risk of knee-jerk reactions and enabling a clearer assessment of both risks and opportunities.
Sacha is a portfolio manager of the Quilter Investors Cirilium and Creation Portfolios. Prior to joining Quilter Investors in 2011, Sacha worked at Broadstone with their team of economists before moving into asset allocation and fund manager research.
Sacha is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. Sacha has a degree in Maths from the University of Bath.
UK roundup: Jobs, growth, and the fiscal outlook
It’s been a busy week in the UK, with labour market figures, April’s GDP data, and the government’s Spending Review all released. In the latest portfolio manager blog, portfolio manager CJ Cowan, unpicks each of these before looking at what this means for investors.
