Decades-old foundational assumptions supporting hedging strategies are being dismantled by the escalating conflict in Iran.

Government bonds, which typically appreciate during market stress to offset equity losses, are now moving in tandem with stocks as oil markets experience unprecedented volatility.

This dynamic is compelling fund managers to explore strategies beyond conventional approaches. Emerging tactics include selected equities, option overlays, niche segments of the credit market, and the US dollar. Specific assets gaining attention include Chinese equities and the Australian dollar, while commodities such as aluminum and soybean oil have witnessed increased demand.

The driving force behind this strategic shift is growing concern over a potential stagflationary shock, where sustained high oil prices could simultaneously fuel inflation and hamper global economic growth. This scenario would render the typical policy response of aggressive interest rate cuts ineffective during an economic downturn. Without central bank intervention, traditional investment portfolios like the 60/40 stock-bond split may again prove inadequate.

“With shifting correlations, the standard rebalancing between equities and bonds, along with instruments like inflation-linked bonds and gold, is no longer effectively protecting portfolios,” stated Rajeev de Mello, a global macro portfolio manager at Gama Asset Management. “The range of options for effective risk diversification has significantly narrowed.”

Goldman Sachs Asset Management has decreased portfolio sensitivity to market fluctuations by implementing non-linear equity downside protection—strategies that limit losses during major sell-offs—credit hedges, and allocating more capital to risk hedging strategies.

Invesco has advised purchasing commodities shipped through the Strait of Hormuz, such as aluminum and grains. Gama Asset Management has increased its holdings of US dollar cash and implemented hedges using equity futures. Pictet Asset Management's multi-asset team has reduced equity exposure, added put options on stocks and corporate bonds, and increased its dollar allocation.

Identifying Safe Havens

As investors search for safe havens, a defensive strategy focusing on multiple themes, including stocks related to nuclear energy and the digital economy, is gaining popularity in Asia, according to strategists.

“Investors should consider a combination of quality-upgrading trades in equity, credit, and currencies, allocations to alternative assets, dynamic risk allocation, and option overlays in equities and across asset classes,” recommended strategists, including Christian Mueller-Glissmann, head of asset allocation research at Goldman Sachs' Global Investment Research division.

They favor selective bearish option spreads, call options on the Euro Stoxx 50 Volatility Index, and put options on European industrial and German equities.

A common strategy has been to increase exposure to the US dollar to weather market instability. Mueller-Glissmann and his team at Goldman Sachs have adopted a tactically neutral stance on stocks and an overweight position in cash, pointing to rising risks that the Middle East conflict could trigger an energy shock reminiscent of the 1970s.

“It still feels premature to make aggressive portfolio changes, especially given recent choppy price movements that would have penalized overly decisive shifts,” said Fesa Wibawa, an investment manager based in Singapore. “We have made minor adjustments to currency risk, guided primarily by valuation and relative fundamentals, while largely looking past near-term volatility.”

Dollar's Resurgent Role

Unlike the situation in 2022 following Russia's invasion of Ukraine, which also caused energy-led market turmoil, the current shift is occurring in a market that had anticipated dollar weakness. The Bloomberg Dollar Spot Index is near its highest level in almost two months, and options data indicate traders are betting it will climb to its highest point since December.

“Prior to the conflict, the dominant view involved hedging against US assets,” noted Mitul Kotecha, a strategist at Barclays Bank. “Now, the dollar has abruptly re-emerged as a safe-haven asset” and has rallied accordingly.

Chinese equities have surprisingly served as a haven, supported by the rationale that the country's diversified energy sources reduce its reliance on Hormuz shipping lanes and oil imports. Concurrently, the Australian dollar has become a refuge, bolstered by rising oil and gas prices and increasing expectations of a near-term interest rate hike. Malaysia has also emerged as a less obvious target due to its exposure to oil and commodities and its lower correlation with other emerging markets, according to Nirgunan Tiruchelvam, an analyst at Aletheia Capital.

Mitigating Portfolio Risk

“When volatility surges sharply, we often seek to sell it rather than buy it, for instance by selling put options on assets we are willing to own at lower prices,” explained Mohit Mirpuri, a partner at SGMC Capital Pte. “We also maintain safety buffers through short-duration, high-quality bonds and a significant allocation to precious metals like gold and silver.”

Hironori Akizawa, a fund manager at Tokio Marine Asset Management, reported increasing cash levels, as a protracted Middle East crisis could heighten the risk of stagflation. Danny Wong, CEO of Areca Capital, is concentrating on stocks linked to high dividends and local demand.

With traditional asset correlations in a state of flux, managers emphasize that flexibility and selectivity are now more critical than textbook diversification methods.

“Traditional hedges are not attracting their usual safe-haven flows, so we are relying less on broad cross-asset hedges and more on selective stock picking and targeted equity risk management,” said Gary Tan, a fund manager at Allspring Global Investments. “We reduced active risk heading into March by raising cash and rotating into defensive sectors.”