Portfolio Perspective: Escalation or De-escalation?
The geopolitical conflict in the Middle East and the military action dominating the news cycle understandably raise concerns. In addition to the immense human tragedies, the situation creates significant uncertainty for the global economy. Many investors are currently looking at their portfolios and wondering how to act in this situation.
This content has been produced by Kvarn Investment Services Oy, a licensed investment firm supervised by the Finnish Financial Supervisory Authority. The content is intended for informational purposes only and should not be interpreted as investment advice or recommendation. All investing involves risks, and past performance is not a guarantee of future returns.
When the global economy faces crises, an investor's natural first reaction is, understandably, fear.
From an investor's perspective, however, uncertainty also presents an opportunity. Historically, markets have been able to survive and recover from numerous geopolitical crises, and a correctly positioned investor can not only protect their wealth but sometimes even thrive in challenging conditions.
To begin, it is worth stating the obvious: none of us knows how the Middle East conflict will unfold or what its overall impact on the global economy and financial markets will be.
However, we can improve our ability to navigate an uncertain future by breaking the possibilities down into different scenarios.
In this article, we examine two contrasting future scenarios: the prolongation and/or escalation of the conflict, and the calming and de-escalation of the situation.
For each scenario, we present three investment themes and an associated ETF/ETC that we believe could perform well in that specific environment.
Please note, however, that nothing written in this article should be viewed as financial advice. The right way to invest is always highly dependent on one’s individual situation, which no one can determine without knowing your specific circumstances.
Background: Geopolitics and Market Psychology
Before we dive into the scenarios, it is important to understand how markets typically price conflicts like the one in the Middle East.
The geographical area of the current conflict is a nerve center for the global economy, primarily due to energy production and global trade routes, especially the Strait of Hormuz.
When the future is shrouded in the fog of war, investors should always keep one thing in mind:
Markets hate uncertainty, even more than bad news.
When the situation is unclear, investors demand a higher risk premium for almost all assets, which drives prices down. However, once the situation begins to clarify, sometimes even regardless of the outcome, the markets adapt and start looking for a new direction.
Right now, the stock market as a whole is in a situation where uncertainty is very high, and from its perspective, some rather negative trajectories are also on the table.
From a technical standpoint, the major stock indices are currently in a position where the decline seen so far could still be viewed merely as a deep correction within an ongoing uptrend.
If the stock indices drop below their 200-day moving averages (the red line in the graph), the situation would increasingly look like a transition into a full-blown bear market.
This technical ambiguity reflects the fact that, right now, investors should keep an open mind regarding both positive and negative scenarios.
The key to managing the situation is not trying to predict exactly what politicians or generals will do next week, but rather preparing for different scenarios and building a portfolio capable of reacting to either extreme.
Scenario 1: Prolonged Conflict
In this scenario, we assume that the situation in the Middle East will not be resolved in the near future. The conflict drags on, potentially expanding to new areas and drawing in additional nations.
From an economic perspective, this scenario would mean increasing disruptions in oil production, rising freight costs as global supply chains are disrupted, and consequently, growing global inflationary pressures.
Due to accelerating inflation, central banks might be forced to keep benchmark interest rates higher than expected, which in turn slows down economic growth.
Although this scenario sounds justifiably quite grim, certain sectors could even benefit from this kind of macroeconomic environment.
Theme 1: Energy Sector
If the conflict expands, the risks of long-term disruptions to the Strait of Hormuz or other vital oil transport routes grow exponentially. A "geopolitical risk premium" emerges in the market, pushing the prices of crude oil and natural gas higher for a prolonged period.
Energy companies that produce and refine oil outside the crisis areas generate significant profits in such an environment. They also offer a natural hedge for a portfolio: if oil prices remain high and the costly energy drags the rest of the stock market down, the returns from energy companies may balance the portfolio.
Investment Idea:
iShares MSCI World Energy Sector UCITS ETF (5MVW)
This ETF invests globally in the largest energy companies (such as Exxon Mobil, Chevron, and Shell). It offers a broad and cost-effective way to capture the cash flows of the traditional energy sector and benefit from potential spikes in energy prices.
Currently, the fund's price is rising sharply, trading above all of its moving averages. After such a strong rally, it is wise to be aware of the risk of a correction, but in our view, a prolonged crisis creates the conditions for the price surge to continue.
Theme 2: Defense Industry
Prolonged conflicts force nations to recognize the shortcomings in their own defense readiness. We have already seen Europe and the rest of the world significantly increase their defense budgets.
If geopolitical tensions in the Middle East rise, the pressure to rearm and invest in defense technology will accelerate further.
Defense industry companies often have long-term, government-backed contracts that make their businesses relatively resilient even to a general economic downturn.
Investment Idea:
VanEck Defense UCITS ETF (DFNS)
This is one of the few UCITS funds available in Europe that focuses purely on the defense industry. It invests globally in companies operating in the aerospace and defense sector, offering direct exposure to growing military budgets.
The price of this fund has been in a strong uptrend in recent years and appears potentially to be climbing toward new all-time highs right now.
Theme 3: Gold
When fears of inflation and systemic risks grow, capital seeks refuge in historical stores of value. Gold is a traditional safe haven that investors flee to in moments of extreme uncertainty. It does not yield dividends or interest, but it can preserve purchasing power even when the value of fiat currencies weakens and confidence in the global financial system wavers.
Investment Idea: iShares Physical Gold ETC (IGLN)
This exchange-traded commodity (ETC) tracks the price of physical gold. It is a liquid and cost-effective way to add gold to an investment portfolio without needing to buy and store physical gold bars.
Driven by the rise in gold prices, this fund's price has also been in an uptrend for about two years and is currently hovering near its record highs.
A common thread among these three investment ideas is that their prices have all been in a prolonged upward trend.
The psychological challenge of investing in such assets can be that, following their price rallies, they may look "expensive."
In this case, however, investors should ask themselves: have the factors causing the price increase thus far changed? In a scenario where the Middle East conflict is prolonged or escalating, the answer would seem to be negative.
Scenario 2: De-escalation
In the second scenario, we assume that diplomatic efforts yield results. A ceasefire is reached, tensions ease, and the threat of a broader regional war fades.
From the market's perspective, this would be a massive relief. The geopolitical risk premium could melt away from oil prices, lowering costs for businesses and consumers.
Inflation could slow down, giving central banks a freer hand to cut benchmark interest rates and support economic growth. In such a "risk-on" environment, capital flows back into growth stocks and high-risk investments.
Theme 1: Growth Stocks and Cryptocurrencies
When fear recedes and interest rates turn downward, growth stocks and other high-risk asset classes, such as cryptocurrencies, are often the biggest winners.
Growth stocks, whose value is based on cash flows projected far into the future, typically benefit the most in relative terms from a drop in interest rates. At the same time, global technological megatrends, such as the AI revolution, could once again become the market's primary focus without the shadow cast by war.
Investment Idea:
iShares S&P 500 Information Technology Sector UCITS ETF (QDVE)
This fund offers concentrated exposure to the largest U.S. technology companies (such as Apple, Microsoft, and Nvidia). Investing in information technology is an aggressive but historically highly profitable way to capitalize on continuous technological advancement and improving risk appetite.
After a strong rally, this fund's price has pulled back to around its 200-day moving average and has, so far, stayed above it. An optimist might view the situation as a healthy consolidation, where some temporary "air" has been let out of the prices before the next upward move.
Offering even higher risk than tech companies is the cryptocurrency Bitcoin. Typically reacting strongly to improving liquidity, Bitcoin's price has come down sharply over the past six months, and in light of long-term averages, is starting to look "cheap."
Theme 2: Discretionary Consumption
A calming of the geopolitical situation and a drop in oil prices would be like hitting the jackpot for industries such as travel. The largest single expense for airlines is aviation fuel, and a drop in prices would flow straight to their bottom line.
At the same time, consumer confidence in the future could strengthen, and slowing inflation would leave people with more disposable income. This money is often directed toward experiences, travel, and other discretionary spending.
Investment Idea:
iShares S&P 500 Consumer Discretionary Sector UCITS ETF (QDVK)
This ETF invests in travel and leisure companies, such as airlines, hotel chains, and restaurant operators. It could be an excellent "recovery play"—an investment based on a rebound—if de-escalation materializes.
Theme 3: Emerging Markets
Emerging markets often suffer disproportionately from global crises, a strong U.S. dollar, and high energy prices.
If the crisis were resolved quickly, the dollar's value would arguably stabilize or weaken as safe-haven demand drops, and energy prices would turn downward. This would create excellent conditions for emerging market equities to rise.
Investment Idea:
iShares Core MSCI EM IMI UCITS ETF (IS3N)
This is a very broad and cost-effective fund covering all major emerging economies (e.g., India, China, Brazil). It offers effective diversification and significant upside potential as global risk appetite returns.
This fund's price has been in a strong uptrend, relative to which the recent price drop looks like a mere "dip."
In contrast to the first scenario, the psychological challenge with these investments might be that their prices have recently fallen. A short-term drop in a long-term uptrend should then be viewed as a temporary "discount," which the markets will quickly price out if general risk appetite begins to return.
How to Combine These Ideas in Your Portfolio?
Investors do not need to—and generally shouldn't—choose just one scenario and put all their eggs in one basket. An approach worth considering is the so-called Core-Satellite strategy.
You can keep a portion of your portfolio in broadly diversified global index funds (the "core") that perform well in the long run despite crises. With the rest of your portfolio, you can take tactical views ("satellites") according to the themes mentioned above.
You can also build an "all-weather portfolio" by selecting elements from both scenarios. You can invest some capital in technology hoping for long-term growth, but also add gold and defense to your portfolio as insurance in case the conflicts deepen. This ensures you always have a component in your portfolio that performs well in the prevailing market environment.
Conclusion: Take Control
When reading the news, it is easy to feel powerless in the face of major global events. As an investor, however, you do not have to be just a powerless victim of circumstances.
By identifying the underlying macroeconomic forces and understanding how different scenarios affect various industries, you can take an active role and make informed decisions.
Geopolitical conflicts are, unfortunately, a phenomenon of our time, but even they are no reason to panic with your investment portfolio.
Stay calm, understand the risks inherent in your current portfolio, and remember that market disruptions also create opportunities for those who know how to look for them.
Success in the markets amidst global upheavals does not require a crystal ball. Above all, it requires discipline and keeping your nerves in check.
The information and sources presented are for illustrative purposes only. While obtained from sources deemed reliable, their accuracy cannot be guaranteed.