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War in the Middle East and possible investment implications
The war has shaken the global economic equilibrium and threatens to cause stagflation, which means lower growth and higher inflation all across the world.
With my limited understanding, I am sharing three possible scenarios and how these will have an impact on different asset classes:
Scenario 1 (Best Case): Ceasefire announced shortly, and the initiation of talks to reach a solution.
This scenario has a higher probability (50%). It will not help meet the objectives with which the war was started in the first place; however, economic pressures may force both sides to pause. If that happens, equity markets will see a quick recovery, which will be short-lived due to the rising impact of inflation on the back of damaged supply chains and infrastructure. Gold will rise with rising inflation and reduced pressure of selling treasuries to fund economic damage. Long-term debt securities will see a lot of volatility. Lower-rated debt securities (BBB and lower) will come under stress.
The longer the delay in reaching a ceasefire, the more difficult it will be for everything to normalise, with a lasting impact on many economies.
Scenario 2: The war continues for a very long time, the way it has been between Russia and Ukraine, and will become a new normal.
This scenario has a lower probability (25%) because the aggressors do not have the patience to continue to fund the war and suffer severe economic and political damage. This will keep the prices of oil and other products built from crude derivatives much higher for longer. This will result in a long era of heightened inflation, leading to a severe negative impact on equity and long-term debt investments. Lower-rated debt papers & private credit will start defaulting. Gold will see a sustained selling pressure before it starts climbing again.
Scenario 3 (Worst Case): War intensifies to the point of total destruction.
This scenario has a lower probability (25%), as it will be catastrophic for the world economy. It will result in a meltdown of equity markets, rapid defaults in lower-rated and private credit debt papers, and a sharp correction in gold prices. There will be an energy crisis, and inflation will take many years to cool down. This could be a period similar to the Gulf wars in the 1970s, the impact of which lasted a decade. Gold prices will see a sharp recovery after a sell-off.
Although scenarios 2 and 3 have a lower probability, it is still a total probability of 50%.
Now the question comes, how to realign your investment portfolio to deal with any of the outcomes?
In our view, one should stick to asset allocation where not more than 50% of the portfolio should be in large-cap value equity portfolios. Gold should be 15–20% of the portfolio holdings, and debt investments should strictly be made in shorter-duration liquid securities. The asset allocation should be dynamically changed with changes in market valuations and personal risk profile.
I will emphasise once again that in this uncertain world, a portfolio should be diversified across asset classes and across geographies. The focus should be on managing risks instead of chasing returns. Risk management itself will result in better sustainable returns.
If the current situation concerns you regarding your investments, let’s talk.
