The default position for wealth managers in response to the latest turmoil in markets has largely been to do nothing. The general view has been that, since it is impossible to know the trajectory or outcomes from the US/Israeli attacks on Iran, looking long-term and keeping investor portfolios on the same track is the correct position.
The problem with the current environment, however, is that it challenges three key pillars on which client portfolios are traditionally based: bond/equity diversification, higher bond weightings and a reliance on the US.
There is an argument, then, that portfolios do need to shift. The US administration’s increasing fondness for military intervention needs to be set against a wider acceleration in geopolitical threats. Hostile nations are increasing their defence spending, at the same time as Europe has been caught napping on its commitments.
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“The geopolitical landscape has been shifting since early 2000,” argues Joakim Agerback, manager of the Finserve Global Security fund. “While there had been a structural decline in Europe, Russia, China and Iran had really built up their own capabilities and modernised their defence, while also increasing dependency in Africa, Latin America and the Middle East.
“This is what we are seeing play out now. 2025 was a big year for defence – but now, when we look at 2026, the geopolitical landscape continues to shift.” To underline his point, Agerback notes that China has made a commitment to be on a military par with the US by 2049.
With this in mind, it is possible Donald Trump will ‘taco’ out of the Iran conflict as he has done previously from some of his other more globally far-reaching decisions. The trouble is, the US president keeps making such decisions and, every time he does, he disrupts markets, companies and the best-laid plans of finance ministers and central banks around the world.
Skin in the game
This argues for some protection in a portfolio – and Alastair Irvine, fund manager on the Jupiter Independent Funds Team, argues there are other considerations for investors too. “The investment community and the financial community are not bystanders – we have skin in the game,” he says. “We are occupied about opportunity cost, return on capital, discount rates …
“What we are here to do is to make money for investors – but also to protect their assets. Should the wheels finally fall off and the UK find itself in a war, we will be under attack. Physical assets, infrastructure, cables will be destroyed. It may be that you cannot open your Microsoft accounts to get your portfolio valuation.” His conclusion here is that investors need to invest in defence to protect everything else.
A straightforward bond/equity split will not protect investors by itself. Investors need a range of carefully-chosen assets to protect portfolios, which might include defence funds, gold or real assets. During the current crisis, it is only mining and defence companies that have really protected investor capital. Following the UK’s mini-budget of autumn 2022, it was a similar picture.
“Successful investing now depends less on forecasting the economic cycle in isolation and more on understanding how policy choices will evolve and interact in the quarters ahead
This raises the risk of ‘fiscal dominance’, a situation in which the Fed’s flexibility to fight inflation is limited by the US government’s need to keep borrowing and manage its interest costs.”
There are other reasons to reconsider the standard asset allocation mix. Not only does it offer limited protection against geopolitical threats, it also offers weak protection against inflation. In the recent rout, bond and equity markets have fallen in tandem – just as they did in 2022. The movements in the shorter-dated UK government bond yields have been extreme.
Basing a portfolio strategy around the hope inflation will fall seems a poor solution. In a note Is higher inflation here to stay?, Morgan Stanley CIO, wealth management Lisa Shalett points to factors such as labour market constraints, housing shortages and energy bottlenecks as reasons inflation could prove sticky – not to mention the issue of what she calls “fiscal dominance”.
“With federal debt near 120% of GDP and deficits running close to 7%, the US is spending roughly one of every five tax dollars just to service debt,” Shalett says. “This raises the risk of ‘fiscal dominance’, a situation in which the Fed’s flexibility to fight inflation is limited by the government’s need to keep borrowing and manage its interest costs.”
Tricky environment for bonds
This would be a tricky environment for bonds – and independent financial market strategist and historian Russell Napier argues that vast debt levels should give investors pause for thought on their bond allocations. “It makes forecasting significantly easier because this debt has to come down,” he says.
“How does it come down? There are a number of ways – and if you choose the right one, your asset allocation becomes relatively easy. One way is excessively high real GDP growth – perhaps through a productivity revolution. Default is another option – but that is not an easy way out. Hyperinflation meanwhile is socially destructive and has often led to warfare or financial repression.
For Napier, the main option open to governments is higher structural inflation. “I do not rule out a productivity revolution because they are often difficult to predict,” he says. “We have to keep an open mind that it might be a ‘get out of jail free’ card. Barring that, however, inflation is really the only way.”
Increasingly, it is policy – fiscal, monetary and regulatory – that drives growth, inflation and asset prices, rather than the traditional feedback loop from economic fundamentals to policy responses.”
Policymakers would need to try to keep inflation up and bond yields down, adds Napier – and, in a free market, that is very difficult. Either way, it does suggest bonds will struggle. Policy decisions are increasingly intruding on financial market outcomes, says Jon Cunliffe, head of investment office at JM Finn. “Recent developments underline a broader shift in the way economic and market outcomes are determined,” he says.
“Increasingly, it is policy – fiscal, monetary and regulatory – that drives growth, inflation and asset prices, rather than the traditional feedback loop from economic fundamentals to policy responses. In this environment, successful investing depends less on forecasting the economic cycle in isolation and more on understanding how policy choices will evolve and interact in the quarters ahead.
“The policy-driven nature of the current cycle was clearly illustrated in the US towards the end of last year, when a government shutdown in October and November disrupted the production and dissemination of official economic data. With little reliable data released until late November, policymakers and market participants were forced to navigate an unusually ‘noisy’ information environment.”
US exceptionalism’s ‘weak underbelly’
The final issue is the reliance on the US. “The weak underbelly of US exceptionalism is that foreigners own $67tn [£50tn] of US assets – over 270% of GDP,” notes Napier. “This is almost certainly the highest ownership as a percentage of GDP since the 19th century.
“So the more the Trump administration does to undermine our willingness to own these assets, the more we take money out. This might be threatening the rule of law, threatening private sector property rights or even threatening Canada – 80% of Canada’s offshore portfolio assets are in the US. They are now bringing money back and building capacity to make them independent from the US.”
This is a pattern seen across many Western markets. While US assets have proved resilient during this recent crisis, the longer-term implications of the current administration need to be considered. If capital starts to leak away from US markets, it could exert a long-term drag on US assets.
The current environment should give investors pause for thought on their asset allocation assumptions. Are bonds doing the right job? Is the US weighting too high? And is there sufficient protection in a portfolio against geopolitical shocks? If the environment truly has changed, investors will need to do likewise.
