Russia fails to achieve a quick victory

As the conflict in Ukraine enters its second month, there are signs that Russia and Ukraine may be moving closer to a negotiated settlement. This remains far from certain, however, and there has still been little improvement on the ground. Cities and towns have been destroyed and the humanitarian crisis worsens by the day. The global economic burden is also becoming clear, with higher energy and food prices creating cost of living crises in many countries around the world. Despite the additional pressure on consumers and businesses, equity markets have rebounded, though remain slightly below recent peaks. There has been greater volatility in bond markets, with yields moving sharply higher as central banks signal their commitment to raising interest rates to tame inflation.

Worrying signals from bond markets

Historically, high inflation and rising interest rates have preceded economic contractions. Bond market investors are becoming increasingly concerned this will be the case again. Shorter-dated US treasury yields have risen quickly, with the two-year note now yielding 2.3%, compared to just 0.3% six months ago. Longer-dated bond yields have also risen, but not by as much, reflecting concern about the longer-term growth outlook. Investors are now on the look out for yield curve “inversion” which is often regarded as a signal that a recession is on the way. While the risk of a slowdown is higher than it was, we do not expect a recession in the US over the next year. This is based on our view that savings accumulated during the pandemic will provide consumers with a significant cushion to absorb higher costs. Schroders' economists estimate these savings at $2 trillion in both the US and Europe.

Renewed focus on energy transition

The invasion of Ukraine has exposed the flaws in an energy system that is still very dependent on autocratic regimes. This is especially true for Europe, which imports roughly half of its gas and a quarter of its oil from Russia. Just two weeks after the invasion, the European Commission announced a high-level plan to become fully independent from Russian fossil fuels by 2030, with much of the reduction to come this year. This call to “accelerate the clean energy transition” will boost the long-term demand outlook for many companies involved in renewable power and electrification. However, the near-term outlook for these industries could remain challenging as companies grapple with supply chain bottlenecks and rapidly rising raw material costs.

Portfolio positioning

Recent developments have raised the risk of stagflation – a period of high inflation and low or negative growth. We have therefore made some adjustments within our equity allocation. We have sold a Europe ex-UK growth fund, given that European economies are likely to face the greatest pressure from high energy prices alongside our desire to increase the "quality" bias within portfolios. We have also reduced our allocation to funds focused on small and mid caps, tilting portfolios towards larger companies with stronger balance sheets and greater ability to pass on cost increases. We maintain our underweight position in conventional fixed income, which has served us well as yields continue to rise. We prefer to diversify portfolios using alternative assets such as gold, broader commodities and absolute return funds.

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