From Philip Brown, Head of Research, FIIG Securities
The US war against Iran is the new reality of power politics in a world that is leaving behind even the pretence of international law. How investors should navigate this new reality is about understanding which of the old rules still apply, which don’t, and which new lessons must be learnt. Bonds remain much less volatile than equities in a changing world and have performed well, in comparison, during the current instability.
In the short-term, we have had material volatility in both equity and bond prices. You might ask why bonds have fallen in price at all, since a good amount of financial theory suggests that bonds and equities should move in opposite directions.
The sort of shock we are dealing with in the Iran war is something that is more about the total value of the system rather than reapportionment within that system. Thanks to the destruction of the oil assets in the Middle East during this war, the total productive capacity of the world has been reduced. This is a global effect because the price of energy is now structurally higher. As such, the total value of all assets everywhere falls – though not equally. Bonds and equities both drop in price, but the effects on equities are far more pronounced than on bonds.
Also read: Central Banks Can’t Produce Oil
Here’s our understanding of what investors should have learned from the last few days:
- The world is more volatile and going to stay that way: It’s a comparatively simple one, but it bears repeating. The calm considered growth of the past is no longer likely to continue. That will make for more risk everywhere – including financial markets. That suggests that bonds need to be part of investment portfolios since they are far less volatile. But it also means that we ought to be taking care with the particular type of bonds chosen. In our 2026 outlook we discussed the need for floating rate notes to protect portfolios from duration risk should interest rate structures change materially.
- Be careful of the correlations between assets – you need more diversification than you think you do. In large moves, everything tends to move together. For bond market investors, that means having both bonds and equities, but also having different sorts of bonds like fixed, floating and inflation linked in your portfolio.
- Australia can lead market moves – Our markets are already open by late Sunday night in the US. For better or worse, we get to be the canary in the coal mine on many things because of this. Whenever there are large developments over weekends, the Australian market gets to be the first to opine on it. Moreover, many incredibly large decisions are announced over weekends precisely because they want to give markets time to digest them. It wasn’t a coincidence that the original strikes against Iran were made on a Saturday – that was a deliberate choice. For Australian investors, this does mean that we sometimes need to hang tight and wait for the European and American trading sessions since the regulator and/or governmental responses are coming, but not until after our markets are open.
- Inflation trauma is real for markets – and economies – the rise in oil prices is an external event, but with inflation already “out of the bottle” as the saying goes, the market reacted in a very different way. This is probably reasonable. When inflation is already free in the system, it’s much easier for sellers, particularly service providers, to raise prices. Price rises are already expected and so it creates far less consumer pushback.
Crucially, though, bonds and equities don’t fall by the same proportion. Bonds have been much more stable than equities over the war so far and will very likely continue to be so. As risks rise, diversification into bonds and within bonds becomes even more important to portfolios.
