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The Story: Middle East conflict and oil prices above $110 per barrel threaten stagflation risks, with market watchers pricing in a 69% probability of $120 oil by April, forcing investors to reconsider portfolios as bonds and stocks move downward together and traditional diversification strategies stumble.
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Bond funds have taken some small backward steps in recent weeks, thanks in part to the rising risk of Fed rate hikes instead of rate cuts. Undoubtedly, the war in Iran isn’t over yet, and there’s concern that things could escalate further, with oil prices rising above $110 per barrel, a level that would have been unheard of just a quarter ago.
As the Fed look to pause and pivot, there’s concern that stocks and bonds could head lower together as they did in 2022. Indeed, the 60/40 portfolio is facing new challenges, and even portfolios with gold exposure might not be spared as the precious metals follow in the footsteps of stocks and bonds.
An energy shock has been rough on bonds, too
With the conflict in the Middle East, we’re now looking at no rate cuts for the year and maybe even a hike if things get really bad and the energy shock spreads through the economy faster than anticipated. Either way, consumers are poised to feel the impact far beyond the gas pump.
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With Amazon (NASDAQ:AMZN) adding a 3.5% fuel surcharge for third-party sellers and United Airlines (NYSE:UAL) hiking checked bag fees by $10, it appears that consumer-facing inflation might not be all too far off. The longer the Iran war goes on, the greater the risks of a shock that may very well be compared to the one experienced during the aftermath of COVID lockdowns.
Either way, bond ETFs, especially long-duration ones that are more sensitive to the trajectory of rates, could continue to stay volatile for a while longer, maybe even the rest of the year. As bonds become more correlated to stocks on the downside, perhaps it’s time that investors consider furthering their diversification to encompass other assets that might help stabilize in a time of crisis.
While the Fed might not have stagflation on its radar yet, it certainly seems like a bear-case scenario could pave the way for such an environment. And as an investor, it can’t hurt to be prepared for a climate where inflation is stubbornly high and employment is on the weaker side.
Energy stocks are the obvious play
So, where to look? Energy stocks are one obvious play that’s working and could continue to pay off if the conflict in Iran goes on for longer than three weeks. If, by May, the war doesn’t wind down, there’s a chance that energy stocks may be the only thing holding their own in a market landslide.
Of course, swapping your bond ETFs for something like the State Street Energy Select SPDR ETF (NYSEARCA:XLE) raises the bar significantly on your risk profile. Making the rotation could lead to instant punishment if oil nosedives in the next session in a scenario that sees the Iran war resolve peacefully. For investors late to the energy trade, oil and gas plays only make sense for investors who want to defend against higher energy prices.
What happens if oil stays above $100 for longer? Would your portfolio have what it takes to make it through more inflationary pressures? If not, hedging against an expensive energy environment with big oil could be the play.
Oil might have room to run
With market watchers now setting their sights on $120 oil and above, perhaps it’s time to get serious about one’s energy sector exposure, even if it means paying a substantially higher price than before the war began.
Having a look at Polymarket, there’s a 69% chance that oil will hit $120 per barrel in April, with a 39% and 20% chance that it hits $130 and $140, respectively. At this juncture, prices above $120 seem likelier than below $80, especially given the nosediving odds (currently at 13%) that the Strait of Hormuz traffic normalizes by month’s end.
Given how high oil could rise, I’d argue that your average large-cap energy stock is still too cheap. The State Street Energy Select SPDR ETF is heavy (we’re taking a more than 40% exposure) in Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX), both of which could help investors hedge against an oil shock that might give inflation a major second wind.
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