Russia and Ukraine

Though there were warnings, Russia’s invasion of Ukraine came as a shock to both the international community and investors. Tragically, it is also turning into a humanitarian disaster, with many thousands of casualties and close to two million refugees. The economic implications of the invasion, including a steep rise in energy and food prices, are forcing investors to reassess their outlook for the year. Global stock, bond and commodity markets have all experienced elevated volatility. Sadly, this dark chapter overshadows much better news on coronavirus, with falling cases in many countries suggesting that the pandemic is finally nearing its end.

Higher risk of stagflation

While the Russian and Ukrainian economies are small on a global basis, recent events will have significant consequences for global economic activity. Commodity prices are the key transmission mechanism. Prices for many natural resources, not just oil, have risen sharply amid concerns about restrictions on Russian supply. This will mean inflation continues to move higher over the coming months. At the same time, growth could suffer as higher food and energy prices erode disposable income and consumers become more cautious. Given its dependence on Russian energy, Europe is likely to experience the greatest impact in terms of both growth and inflation. The US and Asia should prove more resilient.

Will rate rises be delayed?

The invasion of Ukraine complicates central banks’ efforts to bring inflation under control – and may well change the outlook for interest rates this year. While headline inflation figures look set to rise further, declining real incomes could reduce underlying inflationary pressure. Central banks are likely to tread more cautiously as they wait to see the economic impact. Bond yields have declined slightly from recent highs as investors adjust their expectations for interest rate rises and demand for the safe haven of government bonds increases.

Portfolio positioning

Despite recent volatility, we remain comfortable with our allocation to equities. This is based on our expectation of continued US economic expansion, which should be able to withstand a slowdown in Europe. High inflation meant we were already tilting portfolios towards higher quality companies in a better position to pass on cost increases. This will become even more important in light of recent events. We were also increasing portfolio diversification in recent months, with allocations to alternative assets such as commodities, gold and absolute return funds. Our exposure to a broad basket of commodities and gold have performed particularly strongly this year, helping to protect performance in recent weeks.

Outlook

	Economics	Recent events in Ukraine will result in higher inflation and lower growth, raising the risk of “stagflation.” High commodity prices and continued supply chain disruption are likely to keep inflation high in the near term. Savings built up during the pandemic could provide a cushion for consumers against increased living costs. Interest rates are still likely to rise, but potentially at a slower pace.
	Valuations	Global equities are expensive relative to their own history and need to deliver strong earnings growth to justify current levels. Bonds remain expensive but can still provide “defensive ballast” in portfolios. Alternative assets including absolute return funds and commodities look relatively attractive as a way to increase diversification.
	Sentiment	Geopolitical tensions, inflation and anticipated interest rate rises are weighing on investor sentiment. Consumer confidence is the weakest it has been for over a decade. Volatility has picked up in response to Russia’s invasion of Ukraine as well as concerns over monetary policy tightening.
	Risks	Further escalation of Russia’s actions in Ukraine. Faster than expected increases in interest rates. Elevated asset valuations. Threats to global growth from the impact of high inflation. Further covid variants and vaccine efficacy.

Asset Classes

Asset classes	Current positioning	Medium term view	Current views
Equities			Russia’s invasion of Ukraine has raised the risk of “stagflation” and created a less supportive macro-economic backdrop for equities. It is also resulting in higher volatility. We prefer higher quality companies with the ability to pass on higher input costs. We also maintain conviction in long-term secular themes including healthcare and energy transition.
Bonds			Valuations are expensive. Even so, longer-dated government bonds still have a valuable role to play as defensive assets. We prefer USD and Chinese government bonds due to their relatively higher yields. We also prefer inflation-linked bonds to conventional government bonds at this stage.
Alternatives			Alternative assets have an important role to play in diversifying portfolios. We like absolute return strategies that can generate returns with a low correlation to equity and bond markets. We also like real assets with long-dated, visible revenue streams and commodities.
Cash			Cash has defensive qualities in potentially volatile markets.

Equities

Asset	Current positioning	Medium term view	Current view
Equities			Russia’s invasion of Ukraine has raised the risk of “stagflation” and created a less supportive macro-economic backdrop for equities. It is also resulting in higher volatility. We prefer higher quality companies with the ability to pass on higher costs. We also maintain conviction in long- term secular themes including healthcare and energy transition.
UK			Valuations remain relatively attractive. The FTSE100 is also benefiting from its exposure to cyclical sectors. However, the Bank of England remains under pressure to raise interest rates given continued high inflation - despite domestic growth concerns.
Europe			Given Europe’s economic exposure to Russia (particularly through energy), the inflation and growth outlook for the region is more challenging and could depress consumer sentiment. Monetary policy is likely to remain accommodative. The NextGeneration EU plan, and potentially additional government spending, will also be supportive.
North America			The US is less dependent on energy and agriculture imports than other regions and is therefore somewhat insulated from geopolitical developments. Inflation remains a concern, however, and means that consumer sentiment is the weakest it has been for over a decade. Valuations remain high, although the earnings outlook remains positive.
Japan			A delayed reopening, lower risk of inflation and more fiscal support from a newly-formed government should contribute to stronger economic growth, led by consumption.
Asia/ Emerging markets			An improved outlook for Asia and Emerging Markets, led by China. Chinese lending activity is starting to improve. Greater government spending could also support growth. The earnings outlook remains robust and valuations are now in-line with the 15 year average. There remains the risk of economic disruption from China’s zero covid policy, as well as the potential for further regulatory intervention.

Bonds

Asset	Current positioning	Medium term view	Current views
Bonds			Valuations are expensive. Even so, longer-dated government bonds still have a valuable role to play as defensive assets. We prefer USD and Chinese government bonds due to their relatively higher yields. We also prefer inflation-linked bonds to conventional government bonds at this stage.
Government bonds			Long-dated government bonds provide some portfolio insurance characteristics, despite the backdrop of high inflation. Chinese government bonds offer relatively more attractive real yields with lower volatility.
Investment grade			We prefer shorter-dated bonds and higher quality credit given the more challenging economic backdrop. Opportunities remain within asset-backed securities, which offer a relatively attractive yield.
High-yield			Default rates remain low although the market faces headwinds from rising debt costs and a more challenging economic backdrop.
Inflation-linked			We prefer the US inflation-linked market to both conventional treasuries and the UK inflation-linked market. This reflects the low cost of currency hedging. While inflation expectations are likely to remain high in the short term, we are conscious of the potential impact of rising real yields from very low levels.
Emerging markets			Emerging market bonds offer selective value across both US dollar and local currency debt. Idiosyncratic country risk will remain a significant driver of returns.

Alternatives and cash

Asset	Current positioning	Medium term view	Current views
Alternatives			Alternative assets have an important role to play in diversifying portfolios. We like absolute return strategies that can generate returns with a low correlation to equity and bond markets. We also like real assets with long-dated, visible revenue streams and commodities.
Absolute Return			We continue to see selected opportunities in market-neutral strategies given the divergence in valuations and performance across sectors and markets. The asset class can also help diversify portfolios.
Liquid private real assets			We like the long-dated revenue streams and income available in selected parts of the market. We see good opportunities in digital infrastructure, specialist property and exposure to private companies.
Commodities			Gold is attractive as a diversifier and should provide portfolio insurance in the event of a meaningful equity market correction or growth shock. Broader commodities can hedge against further rises in inflation.
Equity-linked income strategies			Attractive returns especially in times of heightened volatility, but we acknowledge the shorter-term correlation with equities.
Cash			Cash has defensive qualities in potentially volatile markets.

Key

	Positive
	Positive/neutral
	Neutral
	Negative/neutral
	Negative
	Up from last month
	Down from last month

Terms

Spread: the difference in yield between a non-government and government fixed income security.

Duration: approximate percentage change in the price of a bond for a 1% change in yield.