Markets Stay Measured Despite Middle East Tensions

Despite intensifying hostilities between Israel and Iran, global markets remained relatively composed. Oil surged over 7% on Friday amid supply concerns, but gains earlier in the week were modest, suggesting no broad panic. Gold hit a record high as investors sought safety, though the move was measured.

Equities saw mid-week declines across the Nasdaq, S&P 500 and European indices, yet the selling remained orderly, with no signs of extreme volatility. Softer U.S. data—including weaker retail sales and industrial production—also contributed to a risk-off tone, but bond markets remained calm, with only a mild dip in Treasury yields.

IIn currency markets, the U.S. dollar was fairly flat prompting some commentators to speculated that the US might not be viewed as the safe haven it once was, supported by the fact that gold, in contrast,  was up sharply as hostilities commenced. While risk-sensitive currencies like the Australian dollar did weaken, the moves were not disorderly. Emerging market currencies, often a barometer of risk sentiment, also weakened but again in an orderly fashion.

Geopolitics Rarely Dictate Long-Term Returns

While escalating tensions in the Middle East have captured headlines and stoked fears of market volatility, history shows that geopolitical events don't always drive long-term investment returns as much as many assume. In fact, an analysis of major geopolitical shocks over the past century - from World War II to 9/11 to Russia's invasion of Ukraine - reveals that on average, markets tend to largely look through these events. Stocks are down 5% on average in the month following the event, but recover to post an average 3% gain after 12 months.

That said averages can hide a multitude of sins and some events like the 1973 Arab oil embargo did coincide with steep market losses. But on the whole, the lesson is clear - making knee-jerk portfolio changes in reaction to geopolitical risk is often ill-advised. Markets are remarkably resilient and driven more by economic and corporate fundamentals in the long run.

The Valuation Anchor

So what should investors focus on instead during bouts of uncertainty? Company valuations. Starting valuations have historically been a far more reliable driver of future returns than any attempt to predict the path of global events. And valuation discipline matters more than ever in frothy markets when risks are rising.

While overall equity valuations have come down, pockets of euphoric overvaluation remain, especially among defensive names viewed as geopolitical havens. Commonwealth Bank (CBA) is the poster child of this dynamic and its hefty index weight means it impacts nearly all Australian portfolios.

Safety Has a Price: The CBA Case Study

Consider that CBA trades at over 30 times earnings, a 50% premium to its sector, despite analyst expectations of slowing growth ahead. Even in bullish scenarios of a strong economy, robust credit growth, and expanded margins it is difficult to see any upside. More realistic outlooks point to 30-40% overvaluation. This is not completely company-specific but also emblematic of how defensive positioning has made "safety" expensive.

Active managers are leaning against this trend, on average they are materially underweight CBA and overweight other banks as well as erstwhile market darlings like CSL that have fallen from grace. If history is a guide, such positioning tends to pay off as expensive defensives eventually underperform.

Looking forward

None of this is to dismiss geopolitical risks. If conflict in the Middle East materially disrupts oil supply, the impact could be severe. But for most investors, the prudent approach is to stay focused on long-term economic fundamentals and valuations. Chasing "safety" at any price often proves more dangerous than the risk it's meant to avoid.

As investors now await the outcome of the Federal Reserve meeting, they will be weighing the impact of geopolitical risks and softening U.S. data against economic fundamentals that are still quite resilient in the U.S.