Portfolio Stress Testing Amid Middle East Conflict

Given the potential for expanded geopolitical uncertainty in the Middle East, it may be relevant to conduct portfolio stress testing to mitigate investment risk.

Initial Market Impacts

As of the time of this writing, immediate reactions after the conflict began include:

• Increase in crude oil price due to fears that this will have impact on the wider petroleum-producing Gulf region and reduce global supply. Brent Crude Oil price increased 4% on Monday, Oct 9.

• Increase in gold spot price based on its hedging effectiveness in volatile financial markets.

• Financial market reactions remain moderate and relatively calm with no major drops on the stock or bond market (apart from Israel).

Historical Scenarios

We’ve run a few historical scenarios to replicate similar events in the past and illustrate how different investment strategies perform under those scenarios today.

Scenarios

1. 2008: Historic high level of crude oil hit on July 3 amid market fears of conflict between Israel and Iran. There was already stress on the oil supply due to rising tension in Nigeria and an oil pipeline attack.

2. 2011: February with Egypt uprising and Libya civil war captures the period with the highest spike of oil prices amidst the Arab Spring, a time when major uprisings and social violence occurred, including riots, civil wars in Tunisia, Libya, Egypt, Yemen, Syria, and Bahrain.

3. 2022: February to March with Russian invasion of Ukraine, narrowing the period to the one with the largest impact on crude oil prices, when in just one month crude oil rose by approximately 38%.

Relevance

We deem these historic events relevant and similar to a possible longer conflict, as they pose similar concerns on the energy-price-led inflation and political uncertainty, stemming from war.

Methodology

We replicated scenarios using the extreme event stress test from the FactSet Workstation, where scenarios take today's portfolio and hypothesizes what its return would be if an extreme event period were to happen again. We use current factor exposures with factor returns from the event to derive the impact of this event on portfolio returns.

Results

Stock markets slow down or drop under replicated historical events, almost across all regions. In times of volatility and geopolitical risk rising, investors turn to safer asset types. Highlighted from the following chart:

• Larger impact is noticed under the Russian invasion of Ukraine, which happened when the stock market was already trending down with investors’ fears of new COVID mutations.

• Also, 2008 historic high crude oil price replication captures a period amidst the global financial crisis, which adds to this scenario more than just oil price change and Far East political instability.

• Replication of February 2011 period, when uprising and civil wars in Egypt and Libya followed leads to more mixed responses of the equity markets and more moderate overall impact.

As illustrated in the following table, the two bond strategies (Global Treasury and Global Credit) perform consistently across the three historical scenarios. There is:

• More notable loss under the 2022 Russian invasion of Ukraine scenario for the same reasons noted above for the stocks.

• Moderate positive returns under the other two historical scenarios, as those events happened in a downward trending yields environment.

Growth, balanced, and conservative strategies track different allocations between equity and bond markets and show consistently across all scenarios how responses to shocks are:

• More acute in growth strategies (80% allocation to equities, representing the riskier asset type, 20% in fixed income assets)

• More moderate in the balanced strategy (45% in stocks, 55% in fixed income)

• Less prominent in the conservative strategy (only 20% in equities, 80% in credit assets).

The downward trend in the sensitivity of the return from growth to conservative is expected due to the decreasing allocation of equities and increasing of bonds.

Factor Shocks

We’ve also run a couple of factor shocks to replicate.

Scenarios

1. Large (30%) increase in crude oil prices

2. Extreme (50%) increase in crude oil prices

Relevance

Immediate reactions of Far East conflicts include increase in crude oil price as direct impact of the uncertainty they cause on future oil supply.

Methodology

We used factor event-weighted scenarios from the FactSet Workstation, which allow comparison of historical period changes to the supplied shock value saved with the stress test. Periods with changes similar to the stressed value are weighted higher than non-similar periods.

Results

Highlighted from the following charts, we see positive return under both scenarios for stocks and very modest response from bond markets. This confirms the above observation from historical scenarios that just the change in oil price is not sufficient to cause a large negative shock on stock and bond markets. There needs to be other political and economic challenges, so that oil price changes lead to significant negative impact on the market (e.g., financial crisis and fears of a subsequent Covid outbreak)

Among bonds, Global Credit is more sensitive to the shock in oil prices, as this is the riskier of the bond strategies. The main component of the loss stems from the spreads, which are more reactive compared to yield of sovereign bonds.

The growth, balanced, and conservative strategies track different allocations between equity and bond markets and show consistently across all scenarios how responses to shocks are more acute in growth strategies, more moderate in balanced, and less prominent in conservative. This is expected due to the lower allocation of equities and higher allocation of bonds.

In Conclusion

From the stress testing, we can say the fears from Far East conflict and related stress on petroleum production in the Gulf region (leading to increase in crude oil price) would not alone have long-term impact on financial markets.

However, back in time when such geopolitical tension was combined with other economic or financial distress, the impact on financial markets was intensified. Portfolio decision-makers may consider the new tension in the region as a signal to stay alert to geopolitical risks and portfolio vulnerabilities.

This blog post is for informational purposes only. The information contained in this blog post is not legal, tax, or investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.