Navigating geopolitical uncertainty: To hedge or not to hedge

Last week brought risk whiplash – starting and ending with geopolitics, with rate cut debate and questions around earnings in between.

Building on our recent assessment of Middle East unrest and market implications, such events offer a reminder that investors should consider and prepare for geopolitical threats.

To be clear, these most recent events do not derail our constructive view for the year ahead. This is not the first time geopolitical turmoil has been the catalyst of turbulence for investors. Barring a major economic disruption or imbalance – for instance, as we saw in the 1973 Arab-Israeli War – the effect of geopolitics on markets has tended to be short-lived. In the end, staying invested in a diversified, goals-aligned portfolio has benefited through countless geopolitical crises, wars, pandemics and recessions – and we believe that should remain true.

However, risks are higher than before and volatility may continue as investors wait to learn more. If the parties don’t escalate further, and the conflict remains contained, global investors are likely to revert to the status quo, with the economic cycle in the driver’s seat and geopolitics a tail risk. But if the conflict escalates into one with a larger geo-economic footprint (particularly through involvement of more parties or a closure of the Strait of Hormuz), that would warrant greater concern.

For those worried about escalation, the lack of big moves in markets so far offers an opportunity to hedge existing positions. In this piece, we offer some of our top ideas to help nervous investors navigate these uncertain times.

Where to look: mitigate risks and find opportunity

Some geopolitical risk premium already seems priced in: Today’s $86/barrel on Brent crude is about in-line with what we think is “fair-value” based on fundamental dynamics. Beyond the short-term spike, we think oil prices are likely to fall back to mid $80s/barrel in the second half of this year (as higher prices encourage more supply and dampen demand). 

However, meaningful escalation like mentioned above would disrupt oil trade and supercharge prices. To help mitigate the risks, some investors might consider the following strategies:

• Structured notes. While the recent gyrations don’t disrupt our long term view, the recent spike in the volatility is opportune for structured notes. For instance, the VIX, a measure of volatility for the S&P 500, is up 46% in the last 4 weeks and sitting at its highest since October. Structured products can express a variety of views, generating income in more rangebound markets, embedding downside protection, or for the bulls, even capturing upside (or leveraged upside). Outside of equities, for those clients worried about oil price volatility, oil structured notes can generate income while also building in protection.
• Gold. Gold is often considered a safe haven. It’s maintained its store of value for centuries, as any demand always faces finite supply (all the gold that has ever been mined could fill just over three Olympic sized swimming pools). The precious metal has been on a tear higher, hitting all-time highs and rallying more than 20% in the last six months. It now sits at $2,360/oz, thanks to a confluence of dynamics like the rate cut and inflation debate, central bank purchases, and, of course, geopolitical risks. While we’re hovering above our year-end outlook ($2,250-$2,350), it could run further given focus on geopolitics and the fact that retail ETF investors have yet to get involved. To get exposure, we prefer to buy physical gold – and some clients may also overlay options to lock in gains. For more, see our client-approved piece here: Is it a golden era for gold?
• Real assets. Real assets (think infrastructure, transport, and timber) are one of the few asset classes that adjust to moves in inflation. Here, service contracts and rent increases help mitigate against the effects of both expected and unexpected price increases. That not only provides a stable income stream that can keep up with inflation, but also a source of diversification in portfolios. 2022 was case in point: while stocks and bonds sank in their worst year in decades, infrastructure and timber returned more than 10%. 
  

• Assets linked to security spending. Armed conflict is now at an 80-year high, with active and ongoing wars in Europe and the Middle East. Yet, federal spending on national defense, as a percentage of U.S. GDP, has been declining gradually over time. That is changing, and creates a powerful tailwind for defense firms, as well as across applications and sectors like energy, cyber, manufacturing. Take cybersecurity for example, companies and governments are now spending more than ever to protect databases and critical defense systems from cyberattacks. Cybersecurity now constitutes 12% of overall technology budgets, up 3 percentage points since 2020.
• The U.S. dollar. The dollar has surged alongside demand for safe havens. While it’s not the only currency that offers protection in a risk-off environment, it does boast the unique characteristic of being defensive and high-yielding. The chart below shows that when a 60/40 stock/bond allocation sells off, the dollar tends to strengthen (they’re negatively correlated). So, while some form of FX (currency) diversification is always prudent, holding a dollar overweight looks beneficial to us in today’s environment – especially if geopolitics weighs further on risk sentiment.
  

Where to reconsider: what’s not a perfect hedge

Energy stocks. Our view on the sector is solidly neutral. Energy stocks may not always serve as a hedge to oil prices for a few reasons. Energy companies often have diverse operations that extend beyond oil production. They may have exposure to natural gas, refining, petrochemicals, and other segments of the energy industry. As a result, their financial performance may be influenced by factors other than just oil prices, such as natural gas prices or refining margins. Company specific factors may also influence the price of these stocks, such as management decisions and debt levels. Overall, while energy stocks may have some correlation with oil prices, they are influenced by a range of other factors that can impact their performance. Therefore, they may not serve as an ideal hedge for moves in oil prices.

The bottom-line: Diversify

Diversification is the cornerstone of investing in an ever-changing world, enabling portfolios to weather all types of storms: Bad things are bound to happen, and this is not the first time geopolitical turmoil has been the catalyst of turbulence for investors. In the end, staying invested in a diversified, goals-aligned portfolio has benefited through countless geopolitical crises, wars, pandemics and recessions – and we believe that should remain true.

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Index definitions:

VIX is the ticker symbol and the popular name for the Chicago Board Options Exchange's CBOE Volatility Index, a popular measure of the stock market's expectation of volatility based on S&P 500 index options.

The Standard and Poor's 500 Index, or simply the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.

The MSCI World Index captures large and mid-cap representation across 23 Developed Markets (DM) countries. With 1,465 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

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