In addition to being a human rights travesty and geopolitical game-changer, Russia’s invasion of Ukraine on February 24 introduced widespread volatility across the markets, with notable asset price movements in commodities, fixed income, and global equities. It can be tempting during such upheavals to aggressively recalibrate portfolios to capitalize on short-term movements in asset prices and to contain near-term risks. Our Investment Committee has extensively analyzed each asset class given the increased volatility and changes in pricing, and while there have been several dislocations in the investment markets, particularly in commodities, we believe that they are temporary and largely priced in. Therefore, we are maintaining our asset class views established in our 2022 Capital Markets Forecast. We remain focused on building portfolios that will endure over the long term – across market cycles and through geopolitical crises. Essential to that portfolio development is emphasizing investment managers that display a bias for quality investments, as these tend to outperform across market cycles.
Commodities – Market Dislocations Persist but outlook remains the same
From 2011 – 2021[1] the annual return on the Bloomberg Commodities Index was 3.6%, with volatility, as evidenced by the standard deviation, of 14.1%, resulting in a Sharpe Ratio of 0.20. The Sharpe Ratio measures how much excess return you receive for the volatility of holding a riskier asset. During the same period, the S&P 500 Index had a much higher return at 14.4% and slightly higher volatility of 17.8%, resulting in a Sharpe Ratio of 1.00. It is evident from the Sharpe Ratios that commodities have not historically provided a favorable risk-return trade-off versus US equities. Despite the high volatility and low returns, the primary argument for the inclusion of commodities in a portfolio is the diversification benefits derived from a lower correlation to other asset classes. That said, even with lower correlations, we believe an allocation to commodities over the long-term is largely unwarranted because of the unfavorable risk-return profile and proneness to boom-bust cycles. In many ways, a bet for hard assets such as commodities is a bet against technology and innovation as rising commodity prices and/or scarcity of commodities compels inventors/innovators to discover other ways to meet market needs. Given a choice, we think investing in the companies that are developing innovative technologies that improve the efficiency of commodities is a better long-term strategy than investing in the commodities themselves.
Our long-term return assumption for commodities remains at 2.2%, in line with our 10-year forecast for inflation, which is well below our return estimates for other risk-seeking asset classes. Given that we anticipate productivity gains and standards of living will continue to improve going forward as technology advances, we expect that other asset classes such as equities and real estate will provide a better hedge against inflation.
Inflation is at 7.5%[2], at levels unseen since 1982 as extreme fiscal and monetary stimulus injected substantial liquidity into the system over the last two years to combat the COVID crisis. This liquidity shored up consumer and corporate balance sheets driving significant demand for goods and services which outstripped supply and led to supply chain constraints and shortages. Even as these supply constraints abate, we anticipate that inflation rates will remain high in the near term as risk-premiums in the energy sector are above what supply and demand dynamics would dictate, driving higher energy prices because of concerns about supply disruptions from the war. With risk premiums high, some investors might see a short-term opportunity to invest in commodities to protect against inflation and take advantage of the potential supply-side shocks. However, we believe the underlying risks are largely priced into the commodities markets at this juncture, and overall long-term commodities fundamentals remain unattractive.
Fixed Income – Tighter Monetary Policy to Continue
We continue to expect heightened volatility in fixed income, particularly government debt (e.g., US Treasuries, Japanese debt, German Bunds, etc.), as the conflict persists. In the last several weeks, we have witnessed a decline in government yields globally as investors have looked to reduce risk within their portfolios. To the extent higher energy prices become a headwind to global growth, there may be continued downward pressure on risk assets like equities, propelling investors to safe-haven securities such as US Treasuries and other government debt. Looking outside the sovereign debt market, we have thus far seen orderly trading in the debt markets, particularly in emerging markets, and our investment managers are not witnessing indiscriminate selling of securities. Local currency and US dollar-denominated Ukrainian debt combined represent a very small (low single-digit) portion of the overall universe of available debt issues, which has supported the relatively calm market reaction in emerging market debt.
The war between Russia and Ukraine has introduced another level of uncertainty to the US Federal Reserve’s interest rate policy framework, which is a pivotal driver of short to intermediate-term interest rates. The three primary considerations driving the Fed to consider a rate hike include a strong US economy, a very tight US labor market, and US inflation well above the Fed’s 2% per year target. The urgent need to address inflation is the most pressing priority, but the potential for economic implications resulting from the conflict has caused the Fed to consider a more measured approach. The Fed is now contemplating possibilities of negative impacts to global growth and, as such, US economic growth because of potential supply disruptions in the energy markets driving higher energy prices and inflation, and western nations’ sanctions on Russia. However, as Federal Reserve Chairman, Jerome Powell’s testified on Wednesday, March 2, the Fed still sees interest rate hikes ahead at the upcoming Fed meeting scheduled for March 15-16 but will be monitoring the situation closely.
As the Fed is likely to begin its interest rate hiking cycle later this month, floating-rate credit and short-duration fixed income remain attractive even amidst the current geopolitical risks. Floating rate credit should absorb interest rate increases, benefitting from the resetting of coupon payments at a higher level while protecting bond principal due to lack of duration, a measure of interest rate sensitivity. Strong US consumer and corporate fundamentals, including historically low realized and expected default rates, also support our positive view of floating-rate credit. In addition, short-duration fixed income will better position investors to take advantage of higher interest rates as the portfolio matures. During short risk-off periods, floating-rate credit and short duration fixed income with a credit bias will likely underperform the true safe-haven security of government bonds (e.g., US Treasuries, etc.), but these segments within fixed income will still provide differentiated exposure from risk assets such as equities over longer periods.
Overweight US Equities on Relative Basis
For perspective, Russia generates just 1.3%[3] of global GDP in US dollars. That said, it is an important supplier of various commodities globally. On a relative basis, we continue to overweight US equities versus non-US equities, as the US is less dependent on Russian oil and gas supplies than other regions. Europe comprises a substantial portion of the non-US developed markets and is heavily reliant (~40%) on imports of Russian gas. Concerns around supply disruptions have driven energy prices higher, which in turn has pushed up inflation in Europe. February Inflation in the Eurozone hit a record high of 5.8%[4] versus 5.1% in January. With Eurozone inflation forecasts increasing for the rest of 2022, higher prices will weigh on the region’s real economic growth. European stock markets are also facing headwinds from the relatively high exposure to the banking industry, which has significantly underperformed recently as investors assess European bank exposure to Russia. Looking forward, a potential positive is that the elevated geopolitical risk will likely accelerate Europe’s already aggressive investment plans to become more energy independent and increase renewable resources.
For emerging market equities, Russia entered 2022 at an almost 4% country weight in the MSCI EM index. With over a 50% drop at the end of February, the country index weight sat below 2%. Trading was subsequently halted on the Russian stock exchange entering March, and other stock exchanges that trade Russian equities, such as in the US, halted as well. However, some exchanges such as the London Stock Exchange continued to actively trade Russian equities. These equities also dropped dramatically as investors rushed to exit positions.
Investment funds are required to ‘mark-to-market’ the estimated value of these securities, with material haircuts given to arrive at a fair value. So, currently, many investment funds have immaterial Russian stock exposure because whatever Russian holdings remain in the portfolios have been drastically marked down. To further complicate the matter, the FTSE and MSCI indices recently announced that Russian equities are uninvestable and would be removed from their respective EM indices. In this case, these equities are marked down to zero as part of this removal process. Investment managers are in the process of determining whether they will need to do the same. We anticipate that many managers will likely sell their remaining Russian holdings, if the possibility arises, whenever the exchanges open and allow for the trading of Russian equities. But there will be some investment managers that decide to hold onto those securities that they believe are trading below their intrinsic value on the premise that they anticipate a resolution to the conflict soon and the potential for upside.
Even with the dramatic Russian stock market decline, emerging market equities remain a worthwhile asset class in a diversified investment portfolio. That said, a country-specific event such as this war reinforces our belief that EM equities should be invested through an active lens, where astute investment managers potentially can add value through both stock and country selection.
Stay the Course
History is rife with examples of protagonists and analysts misestimating the timeline of war, its course, its anticipated victors, and its ramifications. And throughout history, speculation has been an element of all wars. Thus, in many regards what we have witnessed in this first month of the Russian invasion is nothing new. Going forward, we will continue to monitor the rapidly evolving market and economic conditions in light of our clients’ objectives and portfolios. And we will hope for a speedy resolution that leads to healing for the thousands of families in mourning and in fear and to politically sustainable and lasting peace.
[1] Morningstar
[2] US Bureau of Labor Statistics
[3] World Bank
[4] Eurostat