Russia fails to achieve a quick victory

Though Russian troops have pulled back from Kyiv, fighting continues in many other parts of Ukraine and hopes of a peace deal appear to be fading. The humanitarian crisis worsens by the day, with over 4 million refugees and 6 million displaced within the country. The economic implications of the invasion are also now becoming clearer, as higher energy and food prices lead to hardship around the world. Global markets have been volatile as the risk of "stagflation" (rising inflation and low or slowing growth) continues to rise. Strict Covid lockdowns in China, which could result in further supply chain disruptions, are not helping the outlook. And investors have had little support from central bankers, who continue to 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 almost 2.5%, compared to just 0.3% six months ago. Longer-dated bond yields have also risen, but not at the same pace, 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 set out its 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 prompted us to make some changes to our outlook. We have trimmed exposure to equities where portfolios were meaningfully overweight. We have also made adjustments within our equity allocation, reflecting our more cautious stance. We have reduced exposure to Europe, given our view that European economies are likely to face the greatest pressure from high energy prices. We have also reduced our allocation to funds focused on small- and mid-cap stocks, tilting portfolios towards larger, higher quality companies with strong balance sheets and greater ability to pass on cost increases. We maintain our underweight position in government bonds, which has served us well as yields continue to rise (and bond prices fall). We prefer to diversify portfolios using alternative assets such as gold, broader commodities and absolute return funds.

Outlook

	Economics	The invasion of Ukraine will result in higher inflation and lower growth, raising the risk of “stagflation.” High commodity prices and continued supply chain disruptions, exacerbated by Chinese lockdowns, mean inflation is set to remain 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. Companies need to deliver strong earnings growth to justify current valuations. 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			Despite the recent rise in yields, valuations remain expensive. However, longer-dated government bonds 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			Despite the recent rise in yields, valuations remain expensive. However, longer-dated government bonds 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 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 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.