Q1 2022 – FEBRUARY
Discussing the financial implications of Russia’s incursion into Ukraine feels callous. It has been extremely difficult to watch the situation unfold and come to terms with the destruction and suffering being inflicted on the Ukrainian people. But as always, we must put emotions aside and devote our mental capital to making objective and well-reasoned investment decisions on behalf of our clients.
With well over 100 thousand Russian troops previously amassed along the border, we knew the chances of an escalation were very real. However, the scale of the assault is much broader than we would have anticipated. And while we must adapt our thinking to this new reality, a number of important constants remain. A full-blown confrontation between Russia and NATO remains a low probability, despite unified support for Ukraine from the West and the vast majority of UN member nations. Ignoring second-order effects (we’ll get there momentarily), the immediate blow to the global economy should be limited. Russia and Ukraine’s GDP collectively represent less than 2% of the world total, and foreign ownership of Russian assets (bonds in particular) is relatively low.
The severity of the sanctions placed on Russia and corresponding retaliatory measures bear the greatest significance. Russia is a key exporter of oil and gas, as well as numerous industrial metals and agricultural products. Western Europe is in a particularly precarious spot given their dependence on Russian natural gas exports. But more broadly, a supply shock in commodity markets is especially concerning in the current macro environment, as much of the world grapples with surging inflation. While the energy intensity of the global economy continues to grind lower, to put it bluntly, the world still runs on oil. Per the chart below, spikes in oil prices have preceded numerous recessions in recent decades. Accordingly, the risk of the current reflationary environment devolving into a stagflationary one has risen.
This puts central banks such as the US Federal Reserve in a difficult position, as the “dual mandate” of maximizing employment and price stability can become increasingly at odds with one another. Thankfully, policy rates are starting from a very low level, and would need to be hiked significantly in order to meaningfully impair economic activity. Another critical offsetting factor is fiscal stimulus, which at long last was deployed in response to COVID-19 lockdowns. A combination of tight monetary and loose fiscal policy would help keep inflation expectations anchored with less downside risk to the economy.
In terms of financial markets, we remain cautiously optimistic towards risk assets such as global equities. While carefully monitoring stagflation risk, many of the drivers behind the current expansion remain intact. With a preemptive apology for sounding like a broken record, these include fiscal stimulus, pent-up demand, manageable debt levels and rising household wealth in the US. We expect the equity market shakeout is nearing a climax, as global stocks have already sold off sharply this year and investor sentiment has moderated substantially. However, heightened risks call for further diversification. This is where having a global perspective and a broad universe of investable asset classes adds tremendous value. Our investment team is continuously monitoring the situation and will be both looking for areas where portfolio resilience can be increased and, at the same time, being opportunistic where significant upside exists. Stay tuned!
CASH AND CURRENCIES
Despite numerous central banks recently adopting a more hawkish posture, we expect the reflationary environment to persist. Cash and equivalent holdings remain a viable portfolio volatility dampener; but come with a relatively high opportunity cost as inflationary pressures are likely to remain elevated. We have lowered cash levels below benchmark in client portfolios and deployed cash towards asset classes which offer a better hedge against inflationary value erosion.
Consensus inflation expectations have adjusted higher and “caught up” with the data, which should help decrease downside risk for bond prices. However, the potential for price gains will be limited by the already depressed level of investment grade bond yields, which are negative on an inflation-adjusted basis in most markets. We remain underweight fixed income exposure in client portfolios.
Chinese equities had a challenging year in 2021; facing headwinds including power shortages, a regulatory onslaught against internet companies, the high profile Evergrande default situation and restrictive monetary and fiscal conditions. The underperformance last year has left the asset class oversold, attractively valued and brimming with upside potential as policymakers have begun to shift into stimulative territory. We have added Chinese A share (onshore) equity exposure to balanced and growth-oriented strategies this quarter.
Cyclically-oriented commodities including energy and industrial metals should continue to be supported by the underlying reflationary economic environment and a lack of capital investment over the past decade. Sanctions impacting Russian exports will further tighten supply conditions. A position in industrial metals equities was initiated in balanced and growth-oriented strategies this quarter.