The twists and turns of the US-China trade war and Britain’s torturous departure from the EU have consumed asset managers in recent years as they fretted over the possible impact on their portfolios.
But investors this month were jolted by an unexpected threat in the form of volatile oil prices after Saudi Arabia’s oil processing facilities were damaged by drone and missile strikes, knocking out around half of Saudi oil production.
A 20 per cent surge in the price of Brent crude ensued, the largest intraday percentage rise since Saddam Hussein invaded Kuwait in 1990.
Prices later fell after Saudi Arabia, which supplies more than a tenth of global crude, said it had restored half of the lost production and would fully restore output by the end of September. Yet investors remain shaken by the heightened risks signalled by the attacks.
Investors are jittery about any further strikes against Saudi oil facilities or retaliation by the US against Iran, which the superpower blames for the incursion. Such an escalation would further disrupt oil supply and cause prices to spike, increasing the risk of a global recession.
Kristina Hooper, chief global market strategist at Invesco, says the recent hostilities serve as a reminder to investors of the risk of so-called black swan events — unforeseen developments with drastic consequences. “It is definitely a wake-up call for investors. [The Saudi attacks] are one of a variety of possible black swans that can have an impact on portfolios,” she says. “My takeaway from this is that we need to be very diversified and prepare for the unexpected.”
Stefan Kreuzkamp, chief investment officer at DWS, says the attacks demonstrate how easily investors’ base scenarios can be derailed. “[They] show a new level of geopolitical threat that the world economy will have to cope with,” he says.
Investors have experienced oil shocks in the past, most notably in 2008, but Mr Kreuzkamp warns that this one is potentially more alarming because of the ease with which the Saudi processing facilities were damaged. “[It shows] that it only takes a couple of drones to seriously harm vital parts of the global energy backbone,” he says.
Despite the recent reassurances over Saudi oil supply, investors expect oil to command a risk premium from now on as a result of the tense situation. Yerlan Syzdykov, head of emerging markets at Amundi, says that even using a conservative estimate oil is set to trade at least 10 per cent higher than before the attacks.
Fabiana Fedeli, head of fundamental equities at Robeco, believes oil prices had been underestimating the growing risk of military intervention in the Middle East, despite recent signs such as the seizing of tankers in the Strait of Hormuz. “There is a level of complacency that can enter markets. This changes when evidence hits. We’ve hit that turning point with these attacks,” she says.
Yet the muted reaction in equity and bond markets, the S&P 500 lost 0.3 per cent while the FTSE 100 slid 0.6 per cent, suggests that traders do not yet fear more wide-ranging consequences and are waiting to see if the situation escalates.
Following the attack, US secretary of state Mike Pompeo accused Iran of committing an “act of war”, while Mr Trump tweeted that the US was “locked and loaded”.
Mr Syzdykov says that the knock-on effects of any US intervention could be significant. “If we saw an attack materialise on Iranian oil, most of it would be switched out of global supply,” he says, noting that this would be likely to provoke retaliation from Iran or its allies.
Mr Syzdykov warns that other oil-producing Gulf states could be targeted, such as the UAE, which is part of the Saudi coalition engaged in military action in Yemen. “The increasing security risk premium does not only apply to Saudi assets,” he says.
Analysts caution that the US president will be keen to avoid an all-out military conflict with Iran and risk a further surge in oil prices ahead of his re-election campaign next year. Yet Mr Kreuzkamp warns that the current volatile nature of geopolitical dynamics makes the situation riskier. “The number of governments that rely more on quick fixes than on longer term expert assessments [is] on the rise,” he says.
Ms Fedeli adds: “In the past, there would be a build-up of geopolitical risk, but today it can happen more suddenly and easily than you expect. In this era of social media, the world can be turned upside-down by a tweet.”
Some asset managers are taking steps to shield their portfolios from the impact of an oil shock, buying defensive assets such as gold or hedging against higher oil prices. Trevor Greetham, head of multi asset at Royal London Asset Management, says his team is increasing exposure to commodities and buying US energy sector futures.
However, Royal London is keeping its “overweight” exposure to equities, betting that central banks will cut interest rates if oil prices spike, providing crucial support to global growth.
Yet central banks’ intervention powers are limited. “If logic suggests that there is little central banks could do in order to nullify the negative effects of trade wars, economic history suggests they are even less capable to mitigate the effects of any oil shock,” Mr Kreuzkamp says.
Every single US recession in the past 50 years was either caused by, or worsened by, an oil price shock, and all except one of these spikes was linked to conflict in the Middle East, according to Royal London.
Ms Fedeli believes that the impact of more volatile oil prices will be confined to the Middle East, pointing to structural changes to the oil industry in recent years. The US is more oil independent than it was in the past, with shale oil supplies and ample crude oil reserves.
In light of this, emerging market investors are being advised to ensure they are diversified and spread their exposure across oil-producing countries. This is important at a time when international investors are gaining increased access to Middle Eastern capital markets, with Saudi Arabia being included in MSCI’s emerging markets index earlier this year.
Mr Syzdykov notes that while investors may be tempted to replace Saudi exposure with exposure to oil-producing countries outside of the Middle East, such as Russia, they need to be aware of potential tensions that could erupt into those countries too.
“Investors need to be more alert to geopolitical risks,” says Ms Fedeli. “But at the same time they don’t have 20:20 vision and can’t predict the unpredictable.”