Investors face huge challenges over the next couple of months, but the prospects for risk assets and emerging markets particularly look “commensurately brighter” in the second half of the year than the first, according to David Stewart, chief investment officer, Butterfield Group.

As Butterfield notes, the first half of this year saw volatility rise in the Middle East: “Saudi Arabia’s effective annexation of Bahrain in mid-March marked the start of a new phase of volatility and instability in a region not previously lacking in either.”

The private bank goes on to write that the world now faces the possibility of “Greater Saudi Arabia and Iran facing off across the Persian Gulf in a full-on cold war,” implying an arms race.

While the outcome of this is extremely difficult to predict, early consequences came to light when the OPEC meeting in early June fell apart, as Saudi Arabia attempted to raise production quotas but was voted down by Venezuela, Iran and Iraq, according to Butterfield.

“However, the West’s response was swift. Governments in the US and Europe were aware of how weak their economic recovery is, and have concerns that high oil prices would snuff it out,” says Stewart.

The International Energy Agency reacted by releasing 60 million barrels of oil reserves due to supply problems in Libya. This came somewhat out of the blue, the bank notes, as the IEA has previously tended to view the “strategic petroleum reserve as the oil market equivalent of a nuclear weapon: only to be used in the most extreme circumstances.”

Prior to last month, the only two cases of the reserves being used were in 1991, on the first day of the Gulf War, and after Hurricane Katrina in 2005, according to Butterfield. Although the reserves are not infinite, they are very large, and “well-timed interventions,” particularly when they hit speculators, can keep prices closer to levels supported by the fundamentals, says Stewart.

So while this serves to hold prices down to some extent, Saudi Arabia has effectively had to “buy off” its population with $130 billion of social spending – to prevent contagion from the uprising seen in other countries – meaning that the Kingdom now needs higher oil prices just to break even. “[Saudi Arabia’s] breakeven oil price is now $91 per barrel, up from $74 previously,” writes Stewart.

These conflicting pressures imply that while the West has indicated – through the IEA’s actions – that it is intolerant of prices at $115-$120, the world’s largest producer and holder of spare capacity (at some 70 per cent of global spare capacity) “is likely to be equally firm on the lower limit,” saysButterfield Private Bank. Consequently, oil prices may stay within a tighter range going forward, with one of the main risks to this being further pressure on Saudi Arabia to raise social spending, pushing the lower limit up.

“The bigger picture is a further extension of government interference in markets… The key point is that interfering with incredibly complex, adaptive open systems, such as global markets, can often have unintended consequences,” according to the bank’s investment views.

One of the implications of a more stable oil price, with an upper limit on it, is that it will dampen inflationary expectations – which have been concerning investors of late. The signs this is starting to feed through into the system is that growth is already picking up in emerging markets and food price inflation “is perhaps already peaking,” says Butterfield.

“The prospects for risk assets, and emerging markets in particular in the second half of the year look commensurately brighter,” says Butterfield. “But for the moment, we are in the ‘anxious months,’ highlighted when we moved to a more cautious investment strategy stance in the spring. The arguments are finely balanced, but relative valuations and our expectation of stronger economic growth in the second half of 2011 supports our fundamentally positive view on risk assets for now.”