Russia-Ukraine War: Investment Implications for Asset Allocators
The Russia-Ukraine war has highlighted the importance of portfolio diversification. Amid rising stagflation fears, the ballast offered by bonds has diminished. It may be time to consider increasing exposure to alternatives such as real assets.
Russia’s invasion of Ukraine has brought devastation and a humanitarian crisis that is escalating rapidly. How long this war persists and the nature of its ending is very unclear. And that uncertainty has been reflected in heightened financial market volatility as investors try to navigate the short-term ramifications of war and sanctions while contemplating the longer-term implications for investment portfolio allocations.
Financial market attention is firmly focused on the war’s growing impact and establishing what that means across asset classes. No corner of the market is unaffected. We have seen a classic risk-off response from investors, with equities selling off and government bonds regaining some of the recent inflation-driven losses. Meanwhile, the commodities complex has experienced some remarkable price action, reflecting concern around short- and medium-term supply dynamics.
The fast-evolving market conditions partly stem from a reassessment of interest rate expectations. As recently as the middle of February, markets were pricing in 175 basis points of US Federal Reserve rate hikes in 2022 against a backdrop of sustained high inflation. The consensus view now projects a more modest Fed response. Indeed, the market revising down its expectations to about 100bps of tightening suggest a belief that the Fed may choose to tolerate uncomfortably high inflation rather than risk damaging growth. Given this backdrop, the spectre of stagflation (economic stagnation and elevated inflation) looms large in the market’s mind.
How Concerned Should Investors Be?
Uncertainty overshadows every war until a resolution is achieved. But it’s worth noting how markets have reacted over the long term to previous US-involved conflicts. As Figure 1 illustrates, there was a wide range of returns for the US S&P 500 index in the 10-year period after war broke out – going back to World War II. A significant factor in the scale of each recovery was the economic and market backdrop at the time. For example, the 10 years after the start of the Afghan War encompassed the implosion of the dot-com bubble and the Global Financial Crisis, whereas the Vietnam War 45 years earlier came against a backdrop of the roaring Nifty Fifty – this resulted in very different return profiles. So rather than focusing purely on the nature of the war, investors should keep front of mind the health of the market and economy beforehand, and consider what scope governments and central banks have to provide supportive policy measures.
Figure 1: 10 Years of S&P 500 Total Returns Following Outbreak of US-involved Wars
The Asset Allocation Challenge
Ahead of the invasion, the world was emerging from the COVID-19 pandemic. The robust economic backdrop and decades-high inflation meant that the efficacy of bonds as portfolio ballast was starting to come under scrutiny. Historically, falling bond yields would cushion balanced portfolios when equity markets dropped, but as yield levels have slumped since the global financial crisis, their diversifying qualities have become more limited. As inflation remains high and erodes the value of fixed income assets, the potential for lower yields to offset equity declines going forward seems historically low.
We have been telling clients that a prudent approach to the changed environment includes looking for alternative diversifying assets:
‘Safe Haven’ Currencies (US dollar, Japan yen, Swiss franc)
Long Duration US Treasuries
Crucially, it is important that investors don’t overly rely on data and assumptions that shaped the last two decades. Financial markets are in a different place today and regular stress-testing of portfolios with ‘White Swan’ events is recommended.
Inflation-Hedging Real Assets
Investors seeking to protect against a sustained move higher in inflation should look to real assets, which have historically performed well in such an environment, with higher beta and correlation to inflation than traditional assets (Figure 2).
The pick-up in inflation had already seen commodities and natural resources perform strongly and Russia’s invasion has stoked prices even higher.
The sector has been recovering and adjusting its business models to the new reality of the post-pandemic work environment and increased shift to e-commerce.
These may have already experienced much of the increase in inflation expectations. Shifting exposure to shorter-duration securities would be a way to mitigate interest rate volatility and better align with future inflation moves without giving up too much yield at current levels.
If inflation overshoots at sustained higher levels, gold may play a more significant role due to the negative effect inflation can have on broad equity and fixed income exposures.
Figure 2: Not All Real Assets Protect Equally
A Role for Emerging Market Assets
Clearly there are investment implications with regard to Russian assets in the current environment, given widespread sanctions and subsequent index changes. And for the wider emerging markets complex there are other considerations, including rising US interest rates that are traditionally a sensitive issue for EM assets. On the equity front, more selectivity between regions and individual countries is warranted. For example, we believe Chinese equities continue to justify consideration, not least because they have historically been positively exposed to US rates, and are trading around average valuations.
In the EM debt space, a similar situation applies with the local currency bonds most impacted (beyond Russia) being those with a close proximity to the war zone – Hungarian and Romanian currencies have been particularly hard hit. But as with equities we think Chinese Government Bonds can offer diversification and total return. High commodity prices will benefit some countries more than others, while the undervaluation of EM currencies, on an aggregate basis, offers a potential tailwind.
Uncertainty to Remain
War is not only about what happens on the battlefield. We have seen a remarkable degree of Western financial sanctions (an economic war) imposed on Russia and their full effects will take time to emerge. Whether the war is short-lived or not, it is difficult to envisage a quick return to the pre-war geopolitical landscape. It may be that a likely outcome is that Russia holds onto some Ukraine territory, but the trajectory of this war has been surprising in many respects.
For investors, a new normal of higher market volatility seems likely. Other implications could include sustained high inflation being allowed by central banks to run hot for longer, potentially leading to stagflation and raising the importance of inflation hedges such as real assets. The disruption experienced in some supply chains will likely remain for some time as the war impacts trade routes. While oil prices should subside as production gets ramped up in the US and elsewhere, food price inflation could linger longer given the importance of Russia and Ukraine food and fertilizer production.
The information provided does not constitute investment advice as such term is defined under the Markets in Financial Instruments Directive (2014/65/EU) or applicable Swiss regulation and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any investment. It does not take into account any investor's or potential investor’s particular investment objectives, strategies, tax status, risk appetite or investment horizon. If you require investment advice you should consult your tax and financial or other professional advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information.
The views expressed in this material are the views of Altaf Kassam State Street Global Advisors through the period ended 3 February 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
Investing involves risk including the risk of loss of principal.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as "junk bonds", is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable.
There are risks associated with investing in Real Assets and the Real Assets sector, including real estate, precious metals and natural resources. Investments can be significantly affected by events relating to these industries.
Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
This information is for informational purposes only, not to be construed as investment advice or a recommendation or offer to buy or sell any security. Investors should always obtain and read an up-to-date investment services description or prospectus before deciding whether to appoint an investment manager or to invest in a fund. Any views expressed herein are those of the author(s), are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may make different investment decisions for different clients. There are no guarantees regarding the achievement of investment objectives, target returns, portfolio construction, allocations or measurements such as alpha, tracking error, stock weightings and other information ratios. The views and strategies described may not be suitable for all investors. SSGA does not provide tax or legal advice. Prospective investors should consult with a tax or legal advisor before making any investment decision. Investing entails risks and there can be no assurance that SSGA will achieve profits or avoid incurring losses.
Performance quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate, so you may have a gain or loss when shares are sold. Current performance may be higher or lower than that quoted.
Images of NYSE Group, Inc. are used with permission of NYSE Group, Inc. Neither NYSE Group, Inc. nor its affiliated companies sponsor, approve of or endorse the contents of this program. Neither NYSE Group, Inc. nor its affiliated companies recommend or make any representation as to possible benefits from any securities or investments.