Looking beyond the Iran war

The macroeconomic backdrop is proving resilient. On the one hand, the closing of the Strait of Hormuz resulted in a supply shock in essential commodities like oil, gas and helium. On the other hand, there are mitigating factors that suggest that the world economy can absorb this headwind while remaining in growth territory. The Iran war has led us to increase our inflation expectations while slightly reducing our growth expectations. As inflation expectations rise, central banks are increasingly inclined to keep interest rates unchanged or even raise them, rather than pursue further easing. That said, we believe fears of stagflation – a situation with high inflation and low economic growth – are unjustified.

There are three key reasons for this view. Firstly, in our base case we assume the worst of the energy disruption to be over by the end of May. Although conditions are unlikely to return ‘to normal’ immediately, the impact on the medium term would be limited. Secondly, before the war there was an oil oversupply, while after the start of the conflict the oil shortages could be partially mitigated. Existing pipelines are used to bypass the strait, and Asian economies, which are hit hardest by the war, are increasing their use of coal power plants. Thirdly, developed economies have become less energy dependent, meaning energy shocks have a significantly smaller market impact than in the past.

The world economy entered this conflict from a position of strength, and we still expect all regions to show solid growth this year.

The Iran war is not yet resolved, but the talks to extend the ceasefire and negotiations in general have calmed investors. Equity markets have recovered their initial losses, with US equities even reaching new all-time highs. This might seem counterintuitive at first glance, but there are a lot of positive factors that warrant investor confidence. Probably most importantly, companies are doing well with profit margins at record levels in both Europe and the US. Additionally, we expect double-digit earnings growth over the coming year in all major regions. When combined with a solid macroeconomic backdrop and continuing AI investments, we have a recipe for solid equity returns.

Moreover, earnings expectations have risen since the start of the year, while equity returns have been volatile. As a result, valuations have compressed, which means that they have become more attractively priced. The war still brings uncertainty, which is why we aren’t overly optimistic, but we feel comfortable with a modest overweight in equities within our portfolio. Regionally, we prefer emerging markets and are more cautious about European equities.

On a sector level, we increased the IT sector to overweight and reduced that of real estate to strong underweight (both from neutral). The IT sector, and the semiconductor subsegment specifically, can benefit further from the continued AI buildout. Memory chip tightness, broadening AI workloads, and advanced packaging demand all support the semiconductor segment that has now grown to represent half of the total IT sector. This all leads to more resilience to potential economic headwinds. Our more cautious stance on real estate follows from vulnerabilities of specific subsegments, such as structural headwinds for office real estate, as AI adoption and digitalisation reduce demand. In addition, the residential real estate markets continue to face pressure as costs rise and affordability is increasingly constrained, which weighs on investment returns.

Rising inflation expectations triggered by the conflict have pushed bond yields higher, and they have indeed risen substantially since its onset. Credit spreads rose quickly at the start of the conflict but have eased after the ceasefire was announced. Although this market response may appear a bit optimistic, the same arguments supporting a recovery in equities also apply here.

However, the low credit spreads combined with the added uncertainty from the conflict support our cautious position in high-return (HR) bonds as the compensation for the additional risk is too low to be attractive. We continue to prefer high-quality (HQ) bonds and high-quality corporate bonds specifically. These provide additional returns compared to government bonds with similar risk characteristics.

The Iran war has disrupted global markets and is likely to continue to do so in the short term. However, we expect the worst of the energy disruption to be over by the end of May, which should provide breathing room for the economy. This outlook, combined with record corporate profit margins and high earnings growth expectations, has led to a swift market recovery. We maintain a moderately positive view on equities and a neutral view on bonds. Within equities, we prefer emerging markets while being cautious on Europe. On a sector level, we have become positive about the IT sector while becoming cautious about real estate. Within bonds, we prefer HQ bonds over HR bonds. Finally, we continue to hold a positive view on gold, which should be seen as a diversifier.

Richard de Groot 
Chair Global Investment Committee