Ukraine & Russia: War-proofing portfolios

We stay the course

The sudden initiation of hostilities came as a great shock, even though it had always been a possible scenario. Inevitably, the reaction of our board of directors was composed, however our chairman convened an extraordinary meeting on 28 February. This was done to review the investment portfolio and to make sure that everyone was aware of how the portfolio was behaving in the days after the invasion, which were characterised by high levels of volatility. The board also discussed whether there was a need to make immediate changes to the portfolio.

At the meeting, the board was informed that the portfolio was not showing any unexpected reaction to the start of the conflict. The reaction was entirely coherent with the events unfolding and minimal compared with the impact of COVID-19. The only adjustment of the portfolio that was decided consisted of a slight increase of the exposure to gold and, as a result, US dollars. But the adjustment affected only around 1% to 1.5% of the portfolio. Prior to the crisis, we already had an allocation to gold of 3.5% of the portfolio.

Thanks to our balanced allocation to equities and fixed income, and the growing share of real assets in the portfolio, the drawdowns on our equity holdings were compensated by gains from other components, including the 25% exposure to the dollar.

INARCASSA’s exposure to Russian assets was minimal. It consists of around €15m worth of Russian bonds resulting from our index investments in emerging market debt. Our managers are trying to divest from those assets. This is proving to be difficult due to the market conditions, but it will be done as soon as possible.

The behaviour of markets during the first three weeks of March was not dissimilar to the first days after the invasion. As of mid-March, we do not believe that we need to change our strategic asset allocation. Everything depends, of course, on how long the conflict will last and on whether it will spill over. Markets seem to suggest that the situation will continue as it is, and if that is the case, we do not expect significant shifts in markets. The usual pattern of recovery after geopolitical events is likely to repeat itself, with markets recouping losses in the space of a few months. But clearly we have no certainty on what will happen, as it depends partly on non-rational actors.

There are two things we think we know at the moment. First, that tail risk is significant and must be taken into account, and this is a relevant factor in a strategic asset allocation context.

Second, monetary policy has to decisively change course. We believe that the impact of the conflict will be felt more in terms of economic growth than inflation in the medium term, and therefore we are confident about the impact of a more dovish shift in monetary policy.

Central banks cannot and will not be insensitive to the inflation problem, but in the medium to long term they will return to support growth, which will be needed. At the moment, therefore, we are not generally concerned about our fixed-income investments, despite the short-term volatility. We hold firm in our belief that while markets will be highly volatile, company fundamentals will not be as volatile, which favours an allocation to non-listed entities.

The risk of a policy mistake by central banks exists, but in our view it would consist of an aggressive hiking of interest rates, with detrimental effects on economic growth. Our central thesis is that inflation will decelerate during the course of the next quarters, unless the conflict continues or spills over. That should limit the rise in yields on fixed-income assets and allow central banks to slow down their plans to raise interest rates.

A key effect of this crisis will be an acceleration – not a slowing down – of the transition to a greener energy production system. Every initiative aimed at speeding up the transformation of our economies from fossil fuel-dependent to renewable energy-based will be further stimulated, both in terms of financing and fiscal support. As a result, investors will be well compensated for buying assets with strong ESG characteristics.

The risk of monetary policy mistakes has risen

At AP4, we had been monitoring the relationship between Russia and Ukraine for some time, as we were conscious of the military build up between the two countries. During periods of significant uncertainty or volatility in markets, AP4 switches to what we define as ‘standby mode’.

Being in a special working mode means several things. In this case, we focus more on geopolitical risk and the resources we have to analyse it. It also means that senior management meets more often to discuss the portfolio – every day or several times per day, even if we do not trade that often. We need to keep the board informed and to focus our attention and resources on managing the portfolio and the volatility. We will be in this mode for as long as it is required.

“During periods of significant uncertainty or volatility in markets, AP4 switches to what we define as ‘standby mode’”

Our exposure to Russia is minimal. We barely have any Russian fixed income and have a very small indirect exposure through our emerging market equity funds.

Aside from the immediate effects for our portfolio, the focus of our attention is the impact of the crisis on sentiment and on the real economy. There is ample academic evidence that geopolitical events very rarely have a marked and lasting impact on asset prices. We believe that to be the case this time as well, unless the geopolitical situation were to affect the US economy in particular, in which case the impact would be more significant. 

In Europe, we have seen a correction in risky assets, which is to be expected, as the war impacts the European economy through the inflation channel, but also in terms of potentially lower economic growth. 

There is a possibility that the conflict generates a protracted inflationary impulse for not just the European economy, but also globally, even though the impact on Europe is stronger. Russia and Ukraine are both large exporters of wheat and fertilisers and Russia exports large amounts of energy, including oil and gas. If the war results in a ban of Russian exports of oil and gas, inflation could become a long-term problem. However, we must distinguish between the two fossil fuels, because oil is traded globally and there is spare production capacity. 

Before the crisis, our central thesis was that the risk of policy mistakes on the monetary side was high, because inflation was still high and while growth was still above trend, it was decelerating. Central banks could perhaps afford to wait for inflation to decelerate and avoid stifling growth by raising interest rates too early. 

In the current situation, uncertainty is high, which might lead companies to hold off investments and consumers to rein in spending. This could even result in technical stagflation during the second and third quarter of this year, as growth stagnates but inflation continues to stay elevated. 

For central banks, it will be difficult to disentangle the demand effects of the conflict from the supply side issues that have been driving inflation. The narrative in response to the changed environment and central banks are signalling that they will be keeping all options open, which is the correct approach in my opinion. They will need to be patient, and communication will be key. This makes for a higher risk of policy mistakes or miscommunication. This is my top concern with regard to the European Central Bank going into spring and summer of this year.

Reduced exposure to Europe

Veritas does not have direct investments in Russia, but we have had a minimal exposure in some of our emerging market equity and emerging market debt mutual funds. Those investments do not have any material impact on our performance.

The Ukrainian war and sanctions will have wider implications for global inflation and economic growth and that will hurt Europe the most. The global economy has suffered because of the bottlenecks in the global supply chains during the pandemic and that, together with rising demand for goods, caused inflation to rise already last year. Now, the war and sanctions will reduce the supply of energy and agricultural commodities as well as metals and other industrial materials. 

We have already seen fast-rising prices in the commodity markets and that will boost inflation higher all over the world, but mostly in Europe. The shortage of materials will weaken industrial production and decrease economic output which, once again, is a source of inflation.

The European market will probably suffer most from the situation, when rising commodity prices boost inflation and weaken growth. Wage inflation will not rise as much when economic growth decreases and that causes weaker real wages and decreasing demand in Europe. That is also a difficult environment for the European Central Bank, which will be busy fighting inflation.

For these reasons, we have tactically reduced our exposure in Europe, including the Nordics. Instead, we have increased allocation to the commodity-driven developed markets that are not as dependent on Russia, such as Canada and Australia. With emerging markets we are still cautious, but opportunities might arise there if the situation does not get worse.

“We have increased allocation to the commodity-driven developed markets that are not as dependent on Russia, such as Canada and Australia. With emerging markets we are still cautious”

Higher inflation and rising central bank rates will mean a bumpy road for risky assets, especially if valuations are high. Relative to rates, we are more worried about the implied interest rate sensitivity in the asset valuations both in equities and in illiquid real assets. In this environment, it will be important to find assets or factors that do not suffer as a result of rising inflation and interest rates, but that is a difficult task.

We sold most of our already limited exposure to Russian shares and bonds immediately after the crisis started. We are left with some assets, but liquidity has dried up and it is almost impossible to divest completely. The value of those assets has been completely written down.

Protected against inflation

We run an asset-liability management (ALM) study every three years, and this is the year when we compile a new study that may result in a new strategic asset allocation model. In our ALM studies we obviously take into account the current macroeconomic environment and the situation has changed significantly from three years ago, when inflation was not a great concern.

The majority of our assets is in a defined-benefit plan, and because in Belgium salaries are linked to inflation by a factor of one, as inflation increases our nominal pension liabilities increase. The present value may be similar, because the discount rate we use also increases. However, on the asset side, our investments in nominal bonds decrease in value as a result of higher inflation. 

Thankfully, by 2017 we had hedged 50% of our liabilities by investing in assets linked to European inflation. Between 2017 and 2020, this hedge did not add much value, but it is adding value at the moment.

We also have a target allocation of 15% to real assets, including real estate and infrastructure, that we believe will protect us from rising inflation. The target has yet to be reached and at the moment we allocate around 10% to the asset class, but we aim to reach the target in the near future. 

In our DC plans, which have around €500m of AUM, we have a portfolio insurance overlay whose aim is to protect us against equity markets falling off a cliff. As a result of this overlay, about 12% equity exposure was sold at the beginning of February.

The main concern for us is inflation. Equity markets had an excellent 2021. They have not performed as well this year, but this is a level of volatility that can be expected. The possibility of higher volatility was partly the reason why three years agowe decided to get rid of our equity bias towards the European economy, which has served us well.

We believe that the conflict could have a negative impact on global growth, but stagflation is not the base scenario for us. That said, the conflict has wide-ranging growth effects. Germany, for instance, has decided to raise its military budget, and that is money that will not be spent on infrastructure and welfare. 

The conflict may also affect the pace of the green transition, although we do not see it as a major driver. Even before the war, there were a number of obstacles to achieving the targets of the Paris agreement. One is nuclear energy generation, which is needed in greater amounts. Another key element is China, which needs to reduce carbon intensity at a higher pace. These aspects do not seem to be correlated with the war between Russia and Ukraine. 

However, there is a third aspect, which is technological innovation. This is required for the green transition, and geopolitical tensions can divert spending away from innovation in the energy sector and towards military spending instead. That is obviously detrimental in terms of reaching carbon neutrality.

Interviews by Carlo Svaluto Moreolo and Pirkko Juntunen