13 Apr 2022
The Russia-Ukraine war is set to dramatically redefine the global order (or the Grand Chessboard*), both economically and geopolitically. In the near-term, the trade and financial shocks from the conflict and associated sanctions are exacerbating global inflation pressures.
The concurrent hit to growth and to overall confidence is likely to be meaningful, but its magnitude and duration are uncertain. Europe is the most exposed region, with at least a modest recession very likely. While the US is relatively insulated for now, it is not immune either, particularly from the inflationary impacts of the war.
Energy and resource interdependencies are already shifting in what is certain to be a multi-year global adjustment, with implications across numerous asset classes.
* The “Grand Chessboard”, a theory put forward by influential Polish-American political scientist and presidential advisor Zbigniew Brzezinski to describe Cold War era Eurasian power dynamics.
Hear from Global CIO Andrew McCaffery
1. The timeline of the Ukraine war will influence economic outcomes
The war in Ukraine has already caused significant economic damage, and it will continue to shape the near-term outlook for global economies, particularly Europe. Outcomes over the coming quarter will be heavily influenced by the timeline to a resolution and the easing of trade disruptions.
In the meantime, any hopes for a moderation in energy prices and supply-chain disruptions have been dashed. Together, these dynamics will continue to dampen growth and put upward pressure on already high inflation.
This paints an extremely complex picture, both for policymakers and the markets. We believe the market has yet to reflect the full range of possible outcomes, which span extreme left and right tail risks. We advocate nimbleness and the use of hedges, where appropriate.
2. The return of Volckerism
A second major theme for markets for this coming quarter and year is the challenge faced by central banks in reining in inflation given the new geopolitical and economic backdrop. The three major developed markets central banks have turned decisively to a hawkish narrative. In the US, the Federal Reserve has invoked the stance of former Chair Volcker, who tamed inflation in the 1980s, and initiated lift-off at the March FOMC meeting. While we expect the Fed to front load hikes and the ECB to continue its hawkish tone, we believe the war-induced growth shock and the need to maintain negative real rates will lead to dovish pivots by mid-year.
All this could make for a challenging quarter for developed market risk assets. We advocate positioning for the high likelihood of stagflation in developed markets, with a base case of recession in Europe. Careful positioning in risk assets is critical at this stage.
3. Conditions support China outperformance, but this is not 2008
China could serve as a useful diversifier. The region is further removed geographically and economically from the conflict, it benefits from capacity for further monetary and fiscal easing, and it offers more attractive starting valuations.
At the same time, uncertainty remains high. China policy goals are focused on deleveraging, property sector reform and sustainable growth. In this regard, its outlook now looks less straightforward than it did in 2008 during the Global Financial Crisis. We don’t expect China to repeat its previous role as the “fiscal put” that dislodges the global economy from its stagflationary trajectory.
Solutions & Multi Asset
Given the near-term uncertainty around global growth, we now have underweight positions in both credit and equities. We are particularly cautious on European equities and the euro, given the likelihood of recession in Europe.
We have a more positive outlook for emerging market equities, including China, and Asia Pacific stocks excluding Japan, as well as select emerging markets FX, given the diversification potential and possible support for commodity exporters. Finally, we are long USD - we expect interest rate differentials to support the dollar as the Fed remains focused on inflation, and for its defensive characteristics to provide protection should conditions deteriorate.
Equities
We believe focussing on high quality companies, rather than sector selection, is the best approach given the rising geopolitical and stagflationary risks. Companies with pricing power and the ability to protect margins should perform relatively strongly in this environment. Equities should still provide a robust source of income, now that balance sheets have been repaired following the worst of the pandemic.
We are cautious on Europe given the risk of recession there, but see the potential to diversify in some emerging markets, particularly areas that are benefitting from the commodity price surge. Parts of China look cheap, though volatility is very high and tail risks have grown fatter.
Fixed income
Stagflation presents a challenge, but there are some areas within fixed income that we think will be better protected from rising rates and slowing growth. Breakevens should continue to perform relatively well, on the premise that inflation expectations will rise, and we are also cautious on European investment grade given its more defensive characteristics and improved valuations.
Fixed income investors should not fear duration. The upside for nominal yields will likely be capped by debt refinancing constraints, central bank actions and demand for safe havens. We think ECB rate hikes are unlikely in 2022 (despite the ECB sticking to its hawkish tone in March), and so see value in core European duration. We are more cautious on China. The property market remains a concern and we expect further volatility ahead.
Private markets
The direct impact of the war on our portfolios has so far proven limited, with the markets’ resilience meaning there have been few dramatic pricing movements. Nevertheless, the wide-ranging and often indirect supply chain disruptions resulting from the war make this a period for careful active investing and credit selection.
Private credit can prove an effective hedge against inflation due to the floating rate coupons. It also offers a senior position in the capital structure and high levels of income with low volatility.
Our focus now is on companies that can withstand further cashflow and margin pressure.
Real estate
The main risk to real estate right now is slower economic growth. We believe markets have been slow to react to the crisis, and as such we are exercising caution. We are monitoring our existing tenant base for increased risk, and carefully scrutinising any new tenants.
Stagflation is also a concern. Real estate typically fares well through short periods of inflation, but less well in prolonged periods of stagflation. Nevertheless, we are still focused on long-term macro themes - healthcare, residential buildings and data centres - while inflation-linked leases offer a form of inflation protection.
Conclusion
All in all, stagflation risks have intensified, with the war in Ukraine disrupting the global growth trajectory, particularly for Europe, and spillover effects tied to the path and timeline of a resolution. The conflict has also exacerbated inflation pressures, creating even more challenges for policymakers. We have been reducing risk since the start of 2022 and focusing on regions, sectors and asset classes that provide protection and income in a highly uncertain environment of slowing growth and rising inflation.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of an investment in overseas markets. Investments in emerging markets can also be more volatile than other more developed markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuers ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between government issuers as well as between different corporate issuers. Due to the greater possibility of default, an investment in a corporate bond is generally less secure than an investment in government bonds. Sub-investment grade bonds are considered riskier bonds. They have an increased risk of default which could affect both income and the capital value of the fund investing in them. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes.