By Philip Robotham, Head of South Africa, Client Group at global investment manager Schroders

Despite recent diplomatic peace efforts from the US, the Iran/US conflict is now moving into its fourth week, and the situation remains extremely volatile. As the days tick by, risks of a stagflationary environment – where low growth and high inflation coincide – are increasing. This economic scenario has far-reaching impacts for investors, particularly regarding the counterintuitive way certain asset classes may respond.

Prolonged high oil prices move the needle

According to the Schroders economics team, oil prices around $90 per barrel start to significantly alter the calculus on inflation. The longer these prices remain elevated, the bigger the impact on inflation and the squeeze on households. The current energy price spike manifests at the petrol pump, on the utility bill, and later, on food prices through elevated fertilizer costs – impacting both inflation and growth.

Despite these developments, oil prices remain elevated, and recent damage to energy infrastructure means we need to start considering the longer-term impacts of a geopolitical shock that was initially thought by the market to be short-lived. This has meaningful implications for portfolio construction.

Asset allocation as stagflation risk increases

Equities remain a key opportunity for investors in the current environment. While this may seem counterintuitive amid geopolitical risk and volatility, the cyclical backdrop is still supportive. But it's important to differentiate between different markets regionally. The US, as an example, is likely less exposed to the inflationary risk from the energy shock than other markets like Europe and Asia, and may therefore offer more resilience.

As stagflation risk starts to increase, government bonds – which have taken a beating since the Iran/US conflict began - look vulnerable. In addition to this, credit spreads on corporate bonds have also been very tight.

From a commodities perspective, it is likely too late to increase exposure now, as significant geopolitical risk premiums have already been priced in. Furthermore, while gold has traditionally been a good hedge against geopolitical and fiscal risk, as the probability of a stagflation scenario rises, questions must be asked about the role of gold in such an environment. As rate hikes are priced into government bond markets, there may be a better yield on offer by other asset classes, and the opportunity cost of gold effectively goes up.

Views on the US dollar within a portfolio have also shifted, as the currency is reasserting itself in terms of its safe-haven status. The big question from here is the fiscal and monetary policy reaction. Before the latest geopolitical shock, the market was pricing in rate cuts. This has all changed as the flurry of recent central bank meetings suggests authorities are pivoting towards a “wait-and-see” approach, or even hiking rates in some cases. Alongside this, the US economy’s healthy fundamentals and possible stronger resilience against energy shocks are  all factors feeding into a more positive view on the dollar.

From a global real estate perspective, in an environment where inflation is high and rates will be kept on hold or even increase real estate assets with shorter duration income, such as hotels may be negatively impacted. The office sector may also come under pressure as job creation tends to be lower in a low-growth/high-inflation environment. Areas of resilience in the real estate sector will likely be those with leases that have 100% pass-through to the tenants, such as shopping centre companies, mobile network operators, and mobile tower companies.  Additionally, high-demand sectors like aged care, data centres, and necessity-based retail may offer attractive diversification options.

Prepare, don't predict

In nuanced environments like this it’s worth remembering that you have to put your money somewhere. The question is how you allocate it in a way that will leave the outcomes robust to a greater range of outcomes, rather than panicking and being vulnerable to one outcome.

Schroders research has shown that if you stayed invested in the stock market since the early 1990s, when the VIX index, a volatility index known as the “fear gauge”, first started, your returns would have been about 10.5%.

If instead, you had let fear drive decisions when the VIX went above average and disinvested into cash, returns would have been roughly half of that, at about 5.8%.

Overreacting to short-term panic in markets can wreak damage on long-term returns. Conversely, periods of historical stagflation have shown that differentiation and a proactive approach to identifying opportunities can bear fruit for investors despite economic constraints.