The end of the war in Iran has been a scrappy business. Nevertheless, the conflict now appears to be closer to the end than the beginning. Markets have started to respond to the prospect of lower oil prices and less inflationary pressure. Some of the areas hit hardest in the crisis may now be due a recovery.
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Long before this latest Memorandum of Understanding (MoU) was announced, stock markets had started to shrug off the impact of war. Investors appeared to decide that it wasn’t likely to have a material impact on growth trends such as artificial intelligence and mega-cap technology companies have continued to push higher. The S&P 500 is up 13.5% over the past three months alone*.
That said, concerns over inflation, and its impact on interest rates, were still being felt in government bond markets. The UK 10 year gilt, for example, was still at 4.9% when the MoU was signed, around 0.7 percentage points higher than at the start of the conflict. The impact was less acute in other bond markets, but still evident. The US 10-year treasury, for example, was under 4% at the start of the conflict and now sits at 4.5%**.
Bond markets may offer renewed opportunities
Bond investors are a cautious bunch, and are likely to want to see clear signs that traffic has resumed through the Strait of Hormuz before shifting their view. However, oil prices have come down already, easing the pressure on inflation, making interest rate rises less likely. Bond yields should eventually react accordingly. This is good news for fixed income investors, who should see the value of their investments improve.
Colin Finlayson, manager of the Aegon High Yield Bond fund, says: “Bond prices fell quickly as investors reassessed inflation risks. The impact was greater in Europe and the UK where dependence on imported energy left markets more exposed than the US, a net energy exporter.
“Markets are now pricing around two to three hikes over the next twelve months, increasing the appeal of short-dated bonds.” His view is that opportunities are likely to emerge as the pressures unwind. A good selective bond fund, such as Aegon Strategic Bond, is one potential option which takes advantage of these opportunities.
India and smaller companies could benefit most
Within equities, it may spell a more difficult moment for energy equities, which rallied hard in the immediate aftermath of the US/Israeli attacks, but have been lacklustre ever since. However, it may be a better moment for some of the areas that proved most vulnerable during the conflict. India, for example, is a major oil importer and there were fears that a prolonged conflict would damage its buoyant economic growth.
The BSE SENSEX index (the most widely-tracked indicator of the Indian domestic stock market) has performed better over the past three months*** and should now have a tailwind as oil prices fall. The Goldman Sachs India Equity Portfolio is one option for investors in this field. The fund has consistently outperformed its peer group over the past three years, returning 22% for investors****. It is focused on the growth potential of the Indian economy and on investing in sound businesses of all sizes.
Smaller companies are the other area that may benefit from a resolution to the crisis. Smaller companies are often the first to suffer when borrowing costs rise, even if the idea that smaller companies have higher debt doesn’t bear significant scrutiny. The FTSE Small Cap index has rallied over the past three months, rising 8.3%***, in spite of a difficult political backdrop in the UK.
Victoria Stevens, manager of the Liontrust UK Micro Cap fund, says the companies in the portfolio continue to show “strong returns and margins, high levels of cash generation, robust balance sheets and attractive growth rates”, all at knock-down prices. She adds: “Valuations remain a key part of the opportunity, providing both a meaningful margin of safety and the potential for considerable investment returns should valuations revert towards more normalised levels alongside continued earnings growth.” Smaller companies had been starting to recover prior to the conflict and may now be able to resume their trajectory.
Any talk of recovery needs to come with the caveat that the agreement is fragile, subject to third party disruption, and does not address some of the key points of disagreement between the two sides. However, every day that ships are passing through the Strait of Hormuz means there is less pressure on inflation. Areas such as government bonds, India, or smaller companies may be reappraised against that new reality.
