Investor Anxiety is Building; What It Means for Your Portfolio
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Investor Anxiety is Building
During my quarterly call held 10 days ago, I was asked about the impact of the Israel-Hamas conflict on world markets. At the time, my sense was that the conflict would be mostly contained, and therefore the impact to world markets would be modest. The global equity markets seemed to agree; as of last Monday’s close, the S&P 500 index was up 1.51% and the MSCI World Index was up 1.14% over the five trading days since the conflict erupted.
However, since Monday we’ve received new information:
The conflict escalated, with increased rocket fire, discussions of a potential ground invasion of the Gaza Strip, and reports of drone attacks against U.S. bases in Syria and Iraq.
Oil hit $90 per barrel, the highest in over a year.
Jerome Powell spoke at the Economic Club of New York Luncheon, and suggested that amid geopolitical uncertainty, the Central Bank will stay the course of keeping rates higher for longer. (More on this below).
In its latest Financial Stability Report, the Federal Reserve highlighted increased risks to the U.S. financial system largely resulting from higher interest rates.
Markets have reacted appropriately:
The S&P 500 was down four days in a row, and 2.4% on the week.
The S&P 500 breached the 200-day moving average - often a bearish signal - for the first time since March 17.
The VIX (also known as The Volatility Index), which measures the implied expected volatility of the US stock market, hit its highest level since March.
A Wider Conflict is Being Priced Into Markets
Investors are now concerned that the Israel-Hamas war will escalate into a wider conflict in the Middle East. A possible scenario was outlined by Bridgewater Founder Ray Dalio in his monthly newsletter released last week:
“It is very likely the case that the images of civilian casualties we are seeing now and will see during an escalating war in Gaza will lead to new conflicts both between countries and within countries (e.g., repulsive violence against Jewish and Muslim populations in many countries).”
“In my opinion, this war has a high risk of leading to several other conflicts of different types in a number of places, and it is likely to have harmful effects that will extend beyond those in Israel and Gaza. Primarily for those reasons, it appears to me that the odds of transitioning from the contained conflicts to a more uncontained hot world war that includes the major powers have risen from about 35% to about 50%.”
The Monetary Policy Backdrop Remains Challenging
In my letter released October 9th, I pointed out that in light of its focus on 10 Year Treasury Yields, the Federal Reserve may shift to more dovish policy in the near-term. However, in his prepared remarks from earlier this week, Jerome Powell nearly eliminated that possibility, in my view:
“We are attentive to recent data showing the resilience of economic growth and demand for labor . . . Additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.”
What I’m Doing
In light of increased geopolitical risk and signs that Federal Reserve policy will remain restrictive beyond one year, I recommend that we:
Reduce your holdings in growth assets, including stocks.
Reduce portfolio duration by selling some of your longer-dated bond positions and replacing them with shorter-dated bonds.
Increase your allocation to government bonds and decrease your allocation to unsecured corporate and high yield bonds.
Maintain your positions in secured, collateralized loans.
I invite you to reach out to me to discuss your investment strategy.
Best,
Peter Hughes, CFA, CEPA®