Russia’s conflict with Ukraine and the resulting geopolitical tensions have prompted sharp falls in local assets, a shift to a risk-off stance in global markets and soaring commodity prices.
In our multi-asset portfolios, we have reduced tactical risk positions in European and emerging market equities to neutral and moved into cash, while keeping the option open for further reductions should the situation deteriorate. Our main equity exposure is in Japan. We are long commodities and long yen vs. euro.
We increased our short duration position in US Treasuries given our cautious fundamental view on core bonds. The conflict is expected to add to already strong domestic inflation pressures. Longer maturity bond yields appear much too low to us.
Offsetting the impact of higher inflation on nominal yields, geopolitical risks have pushed real rates lower. European forward real rates are 350bp lower than in 2011 when oil prices were last at these levels. Forward real US rates are 125bp lower than levels associated with secular stagnation, which was already a fairly downbeat assessment of the global economy.
Longer term, we believe the role of government bonds as a source of diversification for multi-asset portfolios is questionable. Yields at or around 50-year lows lock in low prospective returns and offer little by way of a protective buffer. Second, all the ingredients for higher yields are here:
- Acute labour shortages
- Large-scale stimulus being rolled back faster than expected
- Globalisation being reversed
- An oil shock overlaid upon a larger and longer lasting inflation shock from Covid-19 than anticipated.
It is not clear to us that it is time to buy broader equity risk; further escalation of the conflict will impact earnings considerably, with Europe hardest hit. Alternatively, any de-escalation would likely see sharp price recoveries. The longer the conflict continues, the greater the downside growth and earnings risk.
A risk of stagflation
History tells us most geopolitical crises have only a transitory affect. This geopolitical event could affect macroeconomic variables. A sustained increase in energy prices will drive inflation higher and lead to slower growth. Oil prices have so far risen by 50% from end 2021; this is unlikely to be sustained even if prices ultimately settle at a higher level. A similar increase in prices in 2011 slowed growth, but did not result in a recession.
The risk of stagflation has certainly increased, but fortunately most of the world’s large economies were forecast to see above-trend growth this year and next, so there is a cushion to absorb any drag.
Markets have so far fallen further than an objective estimation of the economic impact would suggest is warranted. This reflects worries about more sanctions and restrictions on Russian oil and gas exports. Until the market feels this risk has fallen, we can expect volatility and possibly further declines in risk assets.
Central bank tightening and real yields
A deeper, more persistent factor affecting asset prices is the expected tightening in monetary policy. Although the Ukraine conflict has made central bankers more cautious about the outlook, they appear unlikely to meaningfully change course. While the threat to growth would suggest they pause rate rises or quantitative tightening, rising inflation expectations would call for more hikes. Consequently, markets have barely changed their forecasts for the level of policy rates in one year (see Exhibit 1).
We expect the ‘pre-Ukraine’ pattern for rising real yields to reassert itself. We believe the medium-term growth and inflation outlook is superior to the Secular Stagnation ‘New Normal’ of the decade before the pandemic. Real yields should rise towards pre-pandemic levels. Consequently, we are underweight US duration.
Equity valuations: Further normalisation?
We expect equity analysts to begin to incorporate a more downbeat growth outlook into their forecasts. Similar to GDP growth forecasts, there is room for earnings to fall while still posting growth in 2022 and 2023. Earnings growth forecasts have remained good, with 14% year-on-year expected for Japan, 9% for the US, 7% for emerging markets; Europe looks better next year.
Japanese corporates are notable for their high cash levels, attractive valuations, and local policy support. They benefit from their distance from the Ukraine conflict. Emerging market returns may diverge between commodity-exporting EMEA and Latin America relative to commodity-importing Asia. Regulatory changes in China remain a concern.
Declines in equities so far this year have primarily been driven by normalising valuations. Yet, with the exception of Japan and the UK, equities are still not particularly cheap. We will need a stabilisation of the geopolitical situation and a clearer assessment of the earnings outlook before we can determine where valuations are truly attractive.