After Hamas launched horrifying surprise attacks inside Israel’s borders last weekend, the ensuing days have seen continued conflict and the potential for a devastating military response inside Gaza.
This has been a week of escalating tragedy on one of the world’s oldest and most violent political and geopolitical fault lines. It is the biggest military, intelligence and political shock for Israel in decades, and it comes on top of deepening internal divisions.
Today, we consider how investors and asset allocators should think about and respond to events like these.
Given the horror of the attacks, the intensity of the response, the rolling newsfeed and the history of the region, the muted impact on financial markets might be surprising. Bond yields are down but stocks are up, and even gold, oil and defense stocks have rallied only moderately.
The Arab-Israeli “Yom Kippur” War of 1973 has obvious and disturbing similarities to last week’s events. Back then, initial stock-market losses were recovered within a week, but the fallout, including an oil embargo and numerous policy mistakes worldwide, helped trigger stagflation and a multiyear bear market.
Investors appear to recognize that broader Arab-Israeli relations are very different now than they were in 1973, that the world is much less reliant on the region’s fossil fuels, and that Israel, while a much bigger and more advanced economy than it was 50 years ago, is still not large enough to roil global markets.
The caveat to this view was ably provided by Admiral James Stavridis, NATO’s 16th Supreme Allied Commander, the 15th Commander of the U.S. European Command and a member of the boards of the Neuberger Berman funds, in an interview we broadcast last week.
Admiral Stavridis thinks this conflict is likely to remain a one- or two-front war between Israel, Hamas and possibly Hezbollah. He noted that both Hamas and an “emboldened” Iran want to derail the potential rapprochement between Israel and Saudi Arabia, but anticipates a tactical pause rather than a break in those talks. And he assigns a low probability to conflict between Israel and Iran, which would likely follow any proof of a “direct, causative, gave-the-order link” between Tehran and the Hamas attacks.
But he added a stark warning: “As an investor, that is the indicator to watch.”
Should Israel feel compelled to confront Iran, “the U.S. will be engaged,” Russia will “lean, in this instance, toward Iran,” and China, which has recently been trying to build a presence in the region, could find itself torn awkwardly between alliances.
This is the key point for investors, in our view. The risk is that Arab-Israeli distrust of Iran may become a more prominent front in tensions among the U.S., China and Russia—the global players involved in existing geopolitical standoffs and the increasing segmentation of the global trade ecosystem. Like one in a line of dominoes, it has the potential to feed upon and add momentum to existing negative economic and geopolitical trends.
We’ve been writing about the current environment as a major inflection point.
In our view, an extended period of globalization, political and geopolitical consensus, and low inflation is giving way to an age of deglobalization, populist agitation, global tension and higher inflation. We’ve described the four hammer blows against globalization, starting with the Global Financial Crisis, followed by the 2016 Brexit and U.S. Presidential votes, COVID-19 and the invasion of Ukraine.
We believe those trends are heightening the role of governments in the economy and making economic actors prioritize security over efficiency and prosperity. Companies are shortening, localizing and simplifying their supply chains where possible.
That is likely to sustain a higher baseline for inflation and make business cycles and markets more volatile, all other things being equal. We saw further evidence of this with Thursday’s U.S. inflation data, which showed prices still rising twice as fast as the pre-pandemic average—not to mention twice as fast as the central bank’s target.
From this “dominoes” perspective, the events in Gaza sit alongside other recent headlines, such as the success of the populist Alternative für Deutschland (AfD) party in last week’s German state elections, the unseating of the Speaker of the U.S. House of Representatives the week before, and signs of cracks in some Central and Eastern European states in their solidarity with Ukraine.
The results of Poland’s critical parliamentary election will be coming in as this post appears, and next year’s packed election calendar is likely to provide many more examples of rising populism, domestic political division and geopolitical flashpoints, starting with Taiwan in January and ending with the U.S. and possibly the U.K. Next year also has elections in Russia, India, Pakistan, Mexico, South Africa, South Korea and for the European Parliament.
What are the implications for asset allocation?
Asking how to position a portfolio in response to these events is the wrong question, in our view. Instead, we believe investors should step back and ask how to position for the deeper trends of inflation and increased global segmentation.
Those trends have helped push bond yields up—at these levels, bonds can once again act as portfolio diversifiers in growth shocks—but they remain vulnerable to inflation shocks. In our view that makes some exposure to real assets and commodities important in the new environment, alongside bonds.
Genuinely uncorrelated markets and strategies can also help to absorb some of the volatility that arises when bonds and riskier assets trade in lockstep—a more common tendency when inflation is structurally higher. In addition, a tactical asset allocation program may enable you to position for the short-term market moves that often accompany headline events, without allowing them to whipsaw your long-term strategic portfolio.
Finally, it is important not to overcompensate.
As already suggested, that goes for the individual events: Let’s reiterate Admiral Stavridis’ view that serious escalation of the current conflict is unlikely, and that recent Arab-Israeli accords are encouraging and unlikely to be derailed.
But it also goes for the apparently deeper trends.
Yes, the trend toward a more fragmented, fragile and inflationary world is strong. A strategic asset allocation should acknowledge these important structural headwinds. But, as we wrote in our “Brooklyn Bridge” post a few weeks ago, it would be unwise to implement an unbalanced bet against the power of human ingenuity and innovation to offset some of the forces of structural inflation—and indeed, to create a better long-term environment for economic growth and for peace.
Neuberger Berman’s Chief Operating Officer, Andy Komaroff, spoke last week with Admiral James Stavridis, NATO’s 16th Supreme Allied Commander and the 15th Commander of the U.S. European Command, about the military situation in Israel and Gaza and its potential geopolitical ramifications. If you missed it, click here to watch a recording.
In Case You Missed It
- U.S. Producer Price Index: +2.2% year-over-year in September
- U.S. Consumer Price Index: 3.7% year-over-year, 0.4% month-over-month (core Consumer Price Index 4.1% year-over-year, 0.3% month-over-month) in September
- China Consumer Price Index: 0.0% year-over-year in September
- China Producer Price Index: -2.5% year-over-year in September
- Eurozone Industrial Production: -5.1% year-over-year in August
- University of Michigan Consumer Sentiment (Preliminary): -5.1 to 63.0; 1-year inflation expectations +0.6% to 3.8% in October
What to Watch For
- Tuesday, October 17:
- NAHB Housing Market Index
- China Growth Domestic Product
- U.S. Retail Sales
- Wednesday, October 18:
- U.S. Building Permits