There are plenty of risks from here but the worst is that NATO and Western allies are pulled into a wider conflict, either by mistake or by design, causing huge loss of life and a destruction of the supply side capacity within European economies physically impacted by a war. In addition to this, Putin’s escalation has already impacted financial markets, with energy and commodity prices spiking, equities falling (particularly Russian and European equities), bond yields dropping and investor sentiment across financial markets deteriorating.
Specifically on energy, Russia has already restricted the flow of natural gas to the EU. The risk now is that Putin further reduces Russia’s gas exports to Europe, and potentially dials back crude oil exports. The objective would be to create energy shortages in the EU, while pushing up global oil prices to a point where they begin to inflict economic and political pain on Western nations, further destabilising the pandemic recovery. Inflation forecasts will need to be redrawn, with inflation potentially lasting longer and moving higher off the back of energy price rises. Energy was already the main driver of inflation across developed countries.
A key question for investors is what does this means for central banks, who had been signalling a rapid pace of interest rate rises over 2022. While we need more clarity on the situation on the ground to answer this question, our assumption at present is that central banks step back from rate rises until the short-term impact on commodity prices and any impact on aggregate demand is clearer.
Our general advice to clients is to maintain their current investment strategy for now. Portfolios will undoubtedly suffer today on an absolute basis, and there may still be more pain to come over the coming weeks, depending on the Western response and the degree of life lost on the ground.
However, the fact that portfolios are diversified should, we hope, give clients some comfort. There is little exposure to Russian equities across recommended funds, while many equity funds hold energy stocks that are benefiting from higher prices. Portfolios also have much higher weightings than in the past to funds focused on high quality businesses whose earnings stand a reasonable chance of being resilient in an economic crisis. These have fallen with the wider market thus far but we think their defensive qualities will be recognised as the crisis continues.
Government bond allocations also provide protection to portfolios, with prices rising as yields fall. Some funds also contain gold, or the shares of gold miners, which may benefit if investors become even more risk averse. Finally, at the currency level, there is considerable exposure to safe haven currencies such as the US dollar and Japanese yen.
We are keeping the recommended positioning of portfolios under constant review at this challenging time. Taking a long-term view, equities still appear to offer reasonable value, and we do not think clients would be well served by cutting allocations at this time. The challenge with selling risk assets in a crisis with a view to buying them back later when the dust has settled is that prices often move higher before investors become comfortable with them. Holding steady through the decline and recovery is often the better policy, even if it appears emotionally counterintuitive at the time. However, should markets offer compelling bargains, we would not hesitate to recommend selling some of the defensive holdings in portfolios and redeploying the proceeds into areas that appear materially undervalued on a long-term basis, as we have done in the past, such as March 2020.
Please get in touch with your usual adviser if you would like to discuss this note with us.
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