The best way to hedge against war with Iran

If the sabre-rattling over Iran turns into open hostilities, it would be devastating for the global economy. Matthew Partridge looks at the best ways to hedge your portfolio against war in the Persian Gulf.

Most investors think Europe is the biggest threat to their money right now.

But they're wrong. The threat posed by Iran's race for nuclear weapons is greater.

Yes, the situation in Iran is nothing new. Iran has wanted nuclear weapons for a long time. And the rest of the world doesn't want that to happen.

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But it looks like we're approaching a crunch point. And that's why you need to act to protect your wealth now.

The threat posed by Iran

The trouble is that some scientists believe that Iran may now be little more than one month away from getting enough uranium for a nuclear warhead.

Israel in particular, as an obvious target, is very worried about this prospect. Few countries in the world would be viewed as potentially unhinged enough to actually make use of a nuclear weapon, but there are just enough doubts about Iran's leadership to keep the world on its toes if they were to acquire one.

While both the US and the European Union have announced wide-ranging energy and financial sanctions, China continues to buy large amounts of oil from Iran and invest in its energy industry.

As a result, the pressure on Tel Aviv and Washington DC to take more direct action will only increase. And although we've heard this sort of sabre-rattling before, the killing of an Iranian nuclear scientist earlierthis month is a sign that Israel's patience is at breaking point.

So how can you hedge your portfolio?

Geopolitical tension? Buy oil

The biggest concern is that a war in Iran might shut down the Strait of Hormuz, something the country has certainly threatened to do on several occasions. As noted in the current issue of MoneyWeek magazine (if you're not already a subscriber, subscribe to MoneyWeek magazine),40% of thebarrels of oil shipped around the world have to travel through the strait.

How might that affect the price of oil? Similar disruption in October 1973, during the Arab oil embargo, saw prices triple in a matter of weeks. The Iranian revolution in 1979 and the Iran-Iraq war a year later also led to the doubling of crude prices. Such a surge in the oil price would result in stagflation a toxic combination of surging prices and tumbling growth.

Don't always go for the obvious option

Those who bought oil at $34 a barrel at the start of the Iraqi invasion of Kuwait in 1990 had to wait over a decade for prices to reach their former levels. And the fact that the oil price has stayed high in recent months, despite a fairly gloomy demand picture, suggests that the market is already at least partially pricing in the possibility of war in the Middle East.

So while we'd happily stick with gold, which should also benefit if the situation deteriorates, we'd be more wary of oil. Yes, the price would rise if war broke out, but if diplomacy or sabotage can somehow settle things in Iran, and the market starts paying closer attention to the fundamentals for oil, it could fall hard.

A far better strategy would be to invest in arms companies. Planned cuts in military budgets on both sides of the Atlantic mean that the sector is looking particularly cheap just now, with higher dividend yields than the market average.

However, if action ends up being taken in the Middle East, this would surely lead to cuts being either cancelled or reversed. In any case, there is also likely to be increased investment in anti-missile systems and advanced fighter aircraft by Israel and other countries that feel threatened by Tehran.

BAE (LSE:BA), which we tipped last year, is especially well placed, since it is negotiating the sale of fighter jets to both Oman and Saudi Arabia.

Northrop Grumman (NYSE:NOC) is also another longstanding recommendation. As well as a missile division, its strengths in drone technology fit in with the US military's shift away from operations involving large numbers of ground troops.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri