After the deterioration of the situation sadly unfolding in Ukraine and the heavy losses being experienced across financial markets, we wanted to provide our clients with an update. We appreciate that this is a longer note than usual, but hopefully our position on the issues at hand will be clear. Please note that this remains a very fluid situation and the reported views and stated market performance could become outdated very quickly.
What are our expectations for what might happen next in Ukraine?
The situation in Ukraine is appalling and our thoughts are with the people of Ukraine at this difficult time. Our hope from the outset of Russia’s military action in Ukraine has been that President Putin would move to secure those assets that he deemed vital to the safety of Russia, before ceasing hostilities quickly. This does not appear to be likely currently, due to a combination of the strength of Ukrainian defence and the apparent move of Russian forces deeper into territories that did not appear initially relevant to Putin’s suggested aims. Western sanctions and the supposed anger that Putin is alleged to be suffering from also appear to be contributing factors in the wider focus of this attack than was first imagined. The areas of Eastern Ukraine considered by Putin to be “Russian” and the southern Ukrainian ports were obvious early targets, but the recent escalation of Russian aggression now obviously renders any initial views outdated and potentially obsolete.
As we see it today, there are three different scenarios that we must factor into our analysis, all of which could in turn be broken down into various “splinter” scenarios. Whilst the impact on financial markets is, of course, a less important factor than the humanitarian crisis now unfolding, as wealth managers we must continue to analyse how the ongoing events will impact the markets and, ultimately, our clients’ assets.
The War Ends – It could be that early expectations of this miserable situation do ultimately prove correct and once the Russian army has consolidated its gains in Eastern Ukraine and around the Black Sea, they stop the attacks elsewhere in the country. The Russians might have neutralised the perceived military threat they considered the Ukrainians to pose and could force political change upon the country. Our guess is that financial markets would perform well in such an outcome, with upside pressure on commodity prices abating and many markets rebounding in relief, potentially recovering quickly to levels seen a few weeks ago. Whilst this would undoubtedly be a distressing outcome for the Ukrainians, the basic truth is that financial markets would probably bounce back very quickly.
Military Quagmire – Another early theory, which we shared, was that Putin was too smart to lead his troops into a scenario where they became bogged down for months or years fighting in Ukraine. Putin has already witnessed the American-led disasters in Iraq and Afghanistan, as well as his own country’s military missteps in Afghanistan and Chechnya. The likelihood of such an outcome has grown, as the Ukrainians have proven to be heroic foes for the mighty Russian army and the military assistance from Ukraine’s allies has strengthened their determination and aided their ability to fight back. Were a long military conflagration to ensue, the chance of a major mistake from any of the growing list of participants in this conflict would grow still further, and a constant source of risk would remain.
Financial markets have started to price in this eventuality of a protracted war, which is why falls in asset prices have become more widespread and consistent. Such a development would be a disaster for Eastern Europe, but we believe that financial markets would likely start to lose their current focus on this situation and global trends would again reassert their influence over markets’ broad direction.
A Major Global Conflict – As already mentioned, with the possibility of a “mistake” having grown markedly in the last ten days, we cannot ignore the fact that the present situation in Ukraine has raised global tensions to the highest level in decades. Financial markets have not priced in this possibility, and whilst it is significantly more remote than the “quick ending” or “quagmire” scenarios outlined, it would likely be a major concern. The fact that any easy way for Putin to retreat from this situation has been understandably removed by the West heightens this risk further. It is entirely possible that Putin has grand designs beyond Ukraine and believes he has nothing to lose by pursuing an even more extreme plan for regional domination. This would obviously be a major problem for financial markets.
What are the potential longer-run geopolitical considerations?
We have written many times in the past about how the “Turbulent Twenties” was going to see a further development away from the US-centric world that we have lived in since the Second World War. The future, as we saw it, was a “multi-polar” world, with the US and China rivalling each other, hopefully peacefully, for global hegemony. In addition, Russia, Turkey, Iran and other countries that had adopted varying anti-American stances in the last decade could collaborate to ensure they were not locked out of the global economy by American interests and the threat of being barred access from the dollar-based financial system.
At the same time, we believed that regional issues would come to the fore in an era where global geopolitical tensions were high, and that the South China Sea, the Eastern Mediterranean, Eastern Europe and the Sahel provided potential flashpoints to cause the world discomfort and a time of deglobalisation. These concerns are obviously being realised, and we continue to question why there was a combination of the most relaxed attitudes possibly ever demonstrated by investors amidst the clear trend for global disharmony.
What effect will the crisis in Ukraine have upon the global economy?
Before the start of the war in Ukraine, the global economy was growing well, as recent data points have demonstrated. Last week we found out that the latest US employment data and European business confidence surveys (admittedly conducted before the outbreak of hostilities in the Ukraine) were strong and hinted that our view of solid growth in the first half of 2022 looked accurate. In addition, we have learned over the weekend that the Chinese government has set an aggressive growth target for the year ahead, implying that economic assistance will be provided both in the form of fiscal and monetary stimulus. As we discussed in our Outlook for 2022, the early economic trends of 2022 were not likely to be an issue for investors, as the world finally recovered from the “COVID Crisis” and pent- up demand fuelled an economic recovery. This remains our base case for the months ahead, even if risks to this view have increased.
The major problems that we cited late last year were inflation and investor complacency. There is no doubt about it, the crisis in Ukraine has heightened the concerns over inflation. Politicians and central banks will try to share much of the blame for the deleterious effects of rising prices on Putin, but this is an issue that began eighteen months ago, even if rising oil and food prices have been accelerated by recent developments. Inflation will ultimately become a suppressing factor on economic growth, as consumers and companies are forced to spend their money on “staples” as opposed to “discretionary” items, with a greater shares of people’s money being spent on basic foodstuffs and petrol. This remains the biggest issue for the global economy.
So far, there has been a disconnect between the stated aims of central bankers and the pricing of interest rates in financial markets; the former say they are “staying the course” and rates are going up to combat obvious inflation issues, whilst markets say that they will be unable to do so, as economic activity wanes due to heightened global tensions over Ukraine. This could be a classic “Hobson’s Choice”: either rates go up and weigh upon economic growth, or they can’t go up and inflation could become “unanchored”, leading to greater issues later this decade. Somewhere in between is the most likely outcome, with a more gradual approach to interest rate rises now likely due to the problems in Ukraine. In simple terms, our concern over “inflation uncertainty” has risen and the chance of inflation gliding lower quickly has reduced.
Have our expectations for future returns improved or deteriorated in the last few months?
Another obvious trend is that the extraordinary levels of investor complacency seen at the end of last year have reduced. As you know, we have been concerned about market levels and asset class valuations over the last six months. There remains the potential for more of the unprecedented flows we have seen into risk assets to reverse further in the coming months, as many investments are yet to fall back to long-run historical averages from the heady prices of late 2021. However, if the global economy does not tailspin into an untimely recession and central bankers don’t tighten the monetary screw on markets too much, there is the real chance that recent market falls have created a much better outlook for asset market returns over the next few years. Attractive opportunities have been presented to investors across a wide range of assets. While we are not being “gung-ho”, we have started to tactically allocate capital to favoured investments that have been unfairly treated, and we are ready and able to move more aggressively should we become more confident that a major global situation can be avoided.
What has happened to our investment strategies so far in 2022?
The first two months of 2022 were reassuring for our portfolios from a relative perspective: both our diversified approach and specific investment selections helped to cushion the worst of the falls witnessed across global equity and global bond markets. Since the start of March, investing has become much more challenging and falls across markets have become indiscriminate, meaning that the ability to protect as efficiently has become harder. We have been able to offset some of the losses experienced in equity and credit markets through our “hedges” in inflation-linked bonds, commodities and gold investments, whilst our high- quality fixed interest positions have also reduced potential losses. However, falls in many markets in Europe and Asia have become larger as the threat of a growing conflict has risen, reversing the outperformance such markets enjoyed at the start of the year. Assuming that the current crisis doesn’t evolve into the global conflict outcome outlined above, this is probably a “buying opportunity”. We are certainly much more comfortable with equity valuations and excited by some of the valuations and income opportunities available in credit markets. This should increase the potential for future portfolio gains, and we feel strongly that the seeds of future success can be sown in the volatility we are presently experiencing. However, we are being selective and specific and aim to continue with a tactical approach.
Do our portfolios have any exposure to Russia and what has happened to those investments?
All of our strategies had a small amount of exposure to Russian investments through a couple of funds. The exposures were very small and were deliberate. The situation descended so rapidly that acting on the small exposure that we held would have been impossible, and selling the funds that held Russian exposure would have detracted away from our overall long-term strategy, as we would have been “forced sellers” of other investments in those funds that we admired from a long-term perspective. To be clear, our various investment strategies would not have held much more than around 0.50% of total portfolio value across Russian investments, and those investments were in specific high-quality companies and long-term strategic investments, such as gold equities. Before the conflict unfolded, the Russian government and Russian companies were comfortably positioned financially and able to pay their income on their bonds and the principals at the end of the term of the bonds.
The very few companies that our external fund managers had selected were high quality and made solid investment sense, but clearly the investment landscape changed immediately. Those funds that had exposure moved quickly to reduce the impact, where possible.
We have been working very closely with our external fund managers and we would be clear that there should be no further downside from such investments, as the emerging market equity manager that held a tiny Russian exposure has responded to the closure of the Russian market by writing such assets down to 0% (they could well recover some of the losses), whilst the two emerging market debt funds that held small allocations in Russia have written down the investments and have been exiting the positions.
Conclusions
The situation in Ukraine is terrible, and one can only hope it improves rapidly and the country and the people there can recover quickly. Our “base case” is that the situation in the country does stabilise when Putin believes his aims have been achieved, but we must be clear that the chances of both a prolonged military engagement and the possibility of a further increase in global tensions is also possible.
At the same time, the outlook for inflation has become more uncertain and the spike higher in food and energy prices is a suppressant for global economic activity. The growing issues around inflation also make the job of the central bankers harder. In very simple terms, the biggest macroeconomic drivers are in a state of flux and there can be little certainty about the short- to medium-term directions of both the global economy and financial markets.
However, we are far more comfortable with the broad valuations of various global investment markets and increasingly optimistic about the long-term potential of a range of different investments. Such thoughts and views are obviously secondary to the concerns one holds for the people caught up in this horrendous conflict in Ukraine, but we must also recognise our role as custodians of our clients’ capital. For now, we will watch developments and wait to make any major decisions, using a tactical investment approach and relying upon our core philosophies of seeking ways to mitigate inflation risks and protecting against major market shocks.
Please get in touch if we can answer any further questions you might have at this time.
Tom Becket
Chief Investment Officer
[email protected]
[email protected]
www.psigma.com
