The significant build-up of US military hardware in the Middle East in the weeks leading up to what can now safely be called a war between the US and Iran, was, with the benefit of hindsight, an overt warning sign.  However, it was a signal that seemed to have little effect on investor sentiment or market pricing. It is hard to say whether this smacks of complacency or simply reflects the learned behaviour of a multi-decade period of profitable dip-buying or the relatively fleeting effects of geopolitical strife.

Even in the immediate aftermath of the first barrage of missile strikes, markets appeared relatively calm. That calm has subsided somewhat in the days and weeks which have followed. The key issue for global financial markets was, and remains, the impact of these military actions on the flow of oil, gas and fertiliser through the narrow and notorious Strait of Hormuz. As I am sure we all know now, around 20% of global oil supply usually passes through this waterway on a daily basis. That is around 20m barrels per day and the potential for oil supply disruption is of an order of magnitude greater than seen when Russia invaded Ukraine in 2022. Shutting the Strait of Hormuz has long been viewed as the ‘nuclear option’ for Iran. That is because of the massive potential impact. But also because of the potential blowback on Iran itself through reduced fiscal revenue and the significant impact on its ally and main customer for oil, China.

At the time of writing, the Strait of Hormuz is to all intents and purposes closed to shipping. And that means a lot less oil supply for global markets. Understandably the oil price has rocketed. Whether the magnitude of the move is now accurately capturing the extent and duration of disruption to oil markets is impossible to say, but we are certainly in the right ballpark given what we know today.

How quickly the US achieves its vaguely outlined aims, and how Iran responds, are two key questions. The longer the Strait of Hormuz remains closed, the more available oil storage capacity shrinks. The inevitable result is regional producers reduce or ‘shut in’ their production. This has begun and has happened more quickly than most expected it would. The challenge this presents is that disruption timelines subsequently get extended further. Restarting production is not a case of simply flipping an ‘on’ switch. It can take weeks or even months for producers to ramp production back up to previous levels. An elevated oil price for an elevated period of time now seems inevitable.

In recent days we have observed significant column inches being allocated to discussion around the lack of ‘safe havens’ for investors. Equity prices have fallen around the world. However, traditional ports in a storm, such as government bonds and gold, have failed to appreciate in value. This seems to have surprised many. We are less surprised, and for two main reasons.

Firstly, what we are witnessing is, above all else, a shock. It is an event for which markets were neither priced nor prepared. More specifically, shocks tend to follow a pattern. The initial, acute phase of a shock spreads through markets in a very specific way – with volatility as the major means of transmission. Volatility, both realised and that which is implied by option markets, increases. This causes the risk models used by large numbers of professional investors (most notably, but not exclusively, hedge funds) to show that portfolio risk has increased. The size of positions has not changed but the implied ‘riskiness’ of those positions has increased – because they have become more volatile. This so-called ‘value-at-risk’ or VaR model of risk is common and widespread and thus a shock scenario like this – where increased volatility leads to position reduction – has come to be known as a ‘VaR shock’. The result is that positions popular among the investors who manage risk in this way underperform. Meanwhile, assets which those investors are ‘short’ – i.e. expecting to fall in price – outperform. This is regardless of whether these positions are making or losing money and regardless of how much sense these position changes seem to make in the context of the shock.

Observing markets during this acute phase and trying to rationalise the movement of asset prices in a prescriptive way, through a fundamental lens, can result in confusion and the drawing of false conclusions. An example in this instance is the movement of bond yields at the short end of the UK and European yield curves (these are the bonds most sensitive to expectations for future monetary policy). Yields have increased dramatically, such that it appears markets now expect one or two interest rates hikes over the coming months. Just days ago, markets were expecting the Bank of England to cut rates at either its March or April meeting, now it appears that markets believe that hikes are more likely.

Or do they? In fact, what has happened is that a large number of hedge funds, running large and highly leveraged long positions (i.e. expecting interest rates to fall), have been forced out of their positions by their risk management processes. What we see in prevailing pricing is therefore a function of a huge and one-way deluge of flow rather than a considered and rational repricing. This is the essence of a shock.

Another example is gold. Prior to the last few years gold was essentially an investment backwater. The domain of ‘gold bugs’ (people expecting the end of the monetary system), ‘preppers’ (people preparing for the end of civilisation) and doom-mongers (pejorative labelling is a popular and effective way of subverting and discrediting non-consensus views, even when those views contain more than a crumb of validity). Over the last three years, but particularly in the last 12 months, gold has been front page news. Its price has appreciated nearly four-fold and at times the rate of appreciation would have made even some cryptocurrencies blush. I will not reprosecute the gold debate here. Suffice it to say, it is a much, much, more popular and widely held position in the professional and retail investor bases than it has been for many a year. That of course means that gold is also subject to the effects of a VaR shock. Volatility rises and large cohorts of the investor community respond by ‘de-risking’ and that means selling what they own – now including gold.

Beyond the general anatomy of a VaR shock there is an additional and pertinent dynamic here to consider. Not all shocks are equal, of course. Growth shocks, financial shocks, energy shocks and inflation shocks are all different. They can have dramatically divergent impacts on asset prices, even assuming the same starting conditions. What we are experiencing here is a classic energy shock which we believe will, in short order, become a ‘stagflationary shock’. That means it will push up prices and push down growth. These kinds of shocks are a nightmare for just about everyone – most significantly for central banks and for investors.

Central banks are almost universally tasked with managing inflation and thus, prima facie, anything which looks set to push up prices significantly, especially from a starting point of already above-target inflation, should surely result in rate hikes.

It is not that simple, however. The issue with an energy shock is that it is a negative supply shock and, generally speaking, they tend to negatively affect demand, thus often sowing the seeds of their own demise. Prices rise, consumers consume less, producers produce less and prices fall.

Furthermore, monetary policy cannot affect oil supplies and thus in no way are the central bank’s tools an effective cure for the actual problem. All that they could really do is make a bad situation worse by adding more misery to domestic economies already struggling to adjust to higher prices and lower demand. Many central bankers will choose to talk about inflation expectations and how they must not be allowed to get out of control. This is academic talk and largely misses the point. Rising inflation expectations are dangerous when they are effective – that occurs when labour markets are tight. By which I mean when demand for labour is strong and/or supply of labour is weak. Neither of those conditions is true in the vast majority of economies today. If unemployment is rising, then workers are a lot less likely to saunter into their boss’s office and demand a chunky pay rise. Particularly if they could be replaced by one of Elon Musk’s dancing robots any day now…

For bond markets there is thus push and pull. Inflation is never good for bonds and thus, when it is rising, bond yields tend to rise. Falling growth, however, is bad for equities but good for bonds and should tend to pull bond yields lower. How those forces play out in the short term is always hard to assess. However, the starting point was with bond yields towards the low end of their recent ranges. And, with significant monetary easing priced in for the coming year. So, we should not be too surprised to see the combination of VaR shock and rising oil prices (and thus future rising inflation) drive yields higher. That is not though the equivalent of saying that government bonds are no longer a safe haven. Of course, a simple study of financial market history will tell you that bonds are not a great hedge for falling equity prices when the cause of those falling share prices is inflation and monetary tightening. That is what we saw in 2022 – everything sold off together and there was nowhere to hide.

However, my conclusions are somewhat more open minded than some of the musings I have seen in recent days.

Equities may yet look complacent, particularly in the US. Meanwhile, the rise in bond yields increasingly looks like an attractive opportunity to oppose the notion of rate hikes and instead position for the negative growth impacts of this unfolding shock. Do not yet abandon hope for gold as a haven and diversifier either, particularly if central banks hold steady or even cut rates in the months ahead. And definitely not if governments fail to resist their pathological urge to expand already gargantuan deficits to appease politicians and constituents who have long since lost all semblance of fiscal responsibility or realism. I suspect the shiny metal used as money for thousands of years, will once again assert its relevance and appeal in a world of swirling uncertainty and policy irresponsibility.

Stay humble and stay nimble.

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James Athey is Co-Manager of Marlborough's Global Bond & Global Corporate Bond funds.

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This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.