The Russian invasion of Ukraine is impacting global markets in exactly the ways you might expect.
War increases risk aversion, and lowers demand by increasing precautionary saving. It impacts supply by raising the cost of production, as supply chains become even more strained, due to sanctions, loss of production or blockades.
In the specific case of Russia, this would affect energy, fertilisers and food, which are some of Russia’s primary exports.
We can see this below by noting rising credit spreads, higher oil prices, associatively higher break-evens, falling equity markets, a higher USD (flight to quality) and lower real yields.
Note that the invasion is set against the backdrop of the lead-in to the March FOMC meeting, in which the Fed has been widely expected to raise interest rates. This complicates the story, both for us in our reading of the macro-market “tea leaves” and for the Fed itself.
High inflation (running at circa 7.5% in the US) is a reason for the Fed to tighten rates, but additional inflation caused by western sanctions applied to Russian exports is not a good reason to tighten rates, and so the odds of a 50 basis point hike in the Fed funds rate has, in our minds, likely declined.
That appears to be part of the strong rally in tech names we’ve seen overnight, with the NASDAQ rising by over 3% against a more modest rise in the S&P 500.
We’ve been underweight equities for a while now, driven by concerns over a gradually lower and lower (less and less attractive) equity risk premia.
Our expectation that real rates were unduly low and would rise over time in line with Fed tightening combined unfavourably with high valuations for equities, particularly pockets of equities where we detected froth and “irrational exuberance”, mainly tech stocks, health, and secular growth stocks.
This defensive stance has served us well over the past few weeks. As war became increasingly more likely as a base case, we chose to maintain the underweight, and continue to do so, mostly likely until a) we get more clarity on how this current military conflict plays out, which for us in the immediacy means waiting until we cross the weekend and b) reach March, and see what the Federal Reserve announces (50bps or 25bps, and the nature of their balance sheet strategy).
Those are the near-term catalysts that will cause us to add, decrease or maintain our current positions.
Energy fundamentals are extremely tight. A decade’s worth of underinvestment, on a mix of ESG concerns affecting funding and effort to generate better returns via capex discipline, has made for unresponsive supply in the face of resurgent global demand as COVID impacts faded and highly accommodative monetary and fiscal policy settings gained traction. Russia has merely exacerbated this extremely tight dynamic.
In particular, Russia is a sizeable producer of oil and natural gas, fertiliser, and aluminium, which happen to match our direct equity resource exposures of Woodside/Origin (LNG), Incitec Pivot (fertiliser) and Alumina (alumina).
That has been extremely favourable to portfolio performance. However, we are not geopolitical experts, and we are uncertain how large, or how long lasting sanctions that impact those commodities might prove to be.
As such, we are using the elevated market pricing of oil as an enabler to take profits on some of our outperforming exposures, de-risking the portfolio, and rotating selectively into some cheaper tech, teleco, and health names that have either de-rated, or provide low beta stability with high quality.
Perhaps as a final thought, in 2014 following the annexation of Crimea, oil, which had rallied to well above $100bbl, plunged shortly thereafter, as those high prices incentivised increases in US production, and incentivised it as a key means of decreasing reliance on Russia as a player within global energy markets.
We are mindful that the backdrop to 2014 looks remarkably similar to today, with the Fed (tightening), Russia (invading) and China (slowing) largely replaying their prior roles.
As intermediate and longer dated bond yields rose (specifically the 10 year treasury yield) we’ve been nibbling away at our underweight to bonds.
At very low rates, cash and fixed income are essentially substitutes, and hence we prefer the greater liquidity and lower duration risk of cash, at the margin.
As those rates rise, we prefer to reintroduce duration to the defensive part of our multi-asset portfolios, however at time of writing we remain underweight, and don’t anticipate closing it out below a 2.5% yield on 10 year Australian government bonds.
With credit spreads widening, we are somewhat more inclined to narrow our underweight to credit, but have not done so yet. Similarly to our comment on equities, we will wait for the two catalysts of a) further Ukrainian news, and b) a clearer picture on what the Fed intends.
The strong commodity price movements we’ve seen over the past few weeks has been a material positive driver of CTA strategies within alternatives. It’s been a while since we’ve directly mentioned them, but strategies like Aspect’s absolute return fund will likely be performing well (it is half CTA, half value centric strategies) and we have some modest exposures there.
Our equity market neutral strategies are almost zero beta, with no material macro, sector, or factor tilts, and provide good portfolio insulation in volatile conditions, providing us with useful optionality if equity markets should continue to fall.
War is not good for anything. We have been defensively positioned ahead of Russia/Ukraine, however that was for other reasons. We did, however, choose to maintain this defensiveness as the prospect of war rose, and that appears to have been a good decision.
We have used the changes in risk sentiment to sell some outperforming war beneficiaries, for want of a better term, and to rotate into stocks that have sold off, but for the most part, this is all fairly marginal in context of the overall tilts to the diversified investment portfolios.
As long as Europe in aggregate does not descend into war, there are unlikely to be too many negative spill-overs, financially, or otherwise, into the real economy for the world at large, and thus affecting things like GDP growth, or the longer run trajectory of monetary and fiscal policy.
And if it does, we will rely on the aforementioned underweights to risk assets to provide good downside protection.
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