3 Portfolio Tilts to Manage Risks Driven by Russia-Ukraine War
Russia’s unprovoked invasion of Ukraine has ushered in a new era of macro risk and geopolitical conflict. With the humanitarian impact our primary concern, we also are monitoring the war’s impact on global capital markets. Near-term uncertainty is a big challenge. To help you navigate this uncertainty, we explore tactical tilts designed to position portfolios in response to three primary short-term risk and return drivers: the new volatility paradigm, elevated inflation, and tighter central bank policy around the globe.
We never advocate market timing (e.g., going to all cash or all stocks), but these three tilts may help you weather day-to-day market swings while staying focused on clients’ long-term goals.
1. Get Defensive: Diversify for the New Volatility Paradigm
Volatility has spiked across all asset classes, as shown in the chart below. Additionally, the volatility curve of the CBOE VIX Index is inverted (1-month volatility is above 3-month) and each of 1-month, 2-month, and 3-month implied volatilities are all above the 85th percentile over the past five years.1 However, longer-term tenors are not as elevated (e.g., 12-month implied volatility is near the median).
An inverted volatility curve, combined with heightened short-term volatility (within 3-months), reflects a sizable amount of near-term market uncertainty.
Cross-Asset Implied Volatility
Beyond this heightened implied volatility, realized volatility is also elevated. Realized volatility on the S&P 500 is in the 90th percentile over the past three years,2 and this has put pressure on volatility targeting strategies to trim equity exposure to just 40% for a portfolio that targeting 10% volatility.3 That is the lowest equity exposure since the middle of 2020, when the market was rebounding from the COVID-19 drawdown.
So, what can investors do now to manage this volatility? Focus on defense and diversification.
Market Trend Analysis for the MSCI ACWI Index
To defend and diversify your portfolios, consider the following:
- Ultra-Short Treasury exposures, as this market segment has a low correlation to equities and may also be positively impacted (via higher income potential) if the Federal Reserve (Fed) continues to raise rates: SPDR® Bloomberg 1-3 Month T-Bill ETF [BIL].
- Defensive multi-factor equities, such as strategies that may offer downside mitigation while still pursuing upside by focusing on multiple factors beyond the low volatility factor: SPDR® MSCI USA StrategicFactors℠ ETF [QUS].
- Liquid alternatives focused on assets that have a low correlation to bonds and stocks, like exposure to gold: SPDR® Gold Shares [GLD], SPDR® Gold MiniShares℠ Trust [GLDM].4
2. Seek Inflation-Sensitive Exposures as Inflationary Pressures Increase
Energy, agriculture, and metal prices have all seen increases following the invasion – and volatility evidenced by the recent swing in oil where the spot price had both daily double digit gains and double digit losses in the past two weeks.5 This makes sense, given how interconnected Russia is to the supply of some of the major commodities within those sub-categories.
While a lot has been made of the oil and gas impacts, it’s worth noting that Ukraine and Russia account for more than 25% of the global trade in wheat, 20% of corn sales, and 80% of sunflower oil exports. Inflation6 prints, as a result, will continue to be elevated. And, as shown below, Consumer Price Index (CPI) prints that did not factor these supply constraints from sanctions and the war, were already at 40-year highs. Prices paid to U.S. producers show a similar trend as well. The latest data, which was as of February month end and not inclusive of recent events, revealed a 10% year-over-year increase in prices paid.7
CPI YOY (%)
While both CPI and Producer Price Index (PPI) are backward looking metrics, expectations show a similar trend. Breakeven are also moving higher and provide insight into investors’ expectations of the impact sanctions and war will have on inflation.
As shown below, US 2-year breakeven rates are now above 4.5%, and the entire breakeven curve has shifted higher. Yet, the most pronounced effect has been on the short end, reflecting some of the expectations of higher inflation in the near term. This has led Treasury Inflation-Protected Securities (TIPS) to outperform nominal US Treasuries by 2.6% in March and 3.7% for the year.8
The prospects for higher inflation and commodity prices may also continue to provide positive sentiment for natural resource firms. For instance, since 2002 when 12-month average CPI inflation was in the top quintiles (above 3%), natural resources equities outperformed broad equities by 7.5% on average over a 12-month period.9
Natural resource equities, over the past five years, also have a 70% correlation with movements in US 5-year breakeven rates, underscoring the strength of the relationship between commodity-related equities and inflation expectations.10
While natural resource equities are now up 30% on the year,11 realized volatility for the sector has increased. Because the market segment is uniquely tied to current macro events, this will likely continue. After all, any of this sector’s positive sentiment is not immune to today’s higher risk paradigm.
To add inflation-sensitive market exposures, consider:
- Natural Resource Equities through metals and mining firms: SPDR® S&P® Metals & Mining ETF [XME]. Or consider a broader set of commodity-related equities: SPDR® S&P® North American Natural Resources ETF [NANR].
- Inflation Protected Securities by replacing nominal Treasuries with TIPS: SPDR® Portfolio TIPS ETF [SPIP].
- Active real asset strategies, given the level of intra-sector volatility among the real asset sectors, choosing an active strategy may help dampen single commodity specific segments volatility while providing exposure to inflation-sensitive markets: SPDR® SSGA Real Asset Return ETF [RLY].
3. Mitigate the Impact of Higher Rates with Real Income
Rates and inflation trends are connected. And the elevated inflation prints are likely to keep the Fed on track to raise rates, beyond the 25 basis point increase from the March meeting.12 More important will be how many times the Fed raises rates this year. The market currently expects six more, as does the Fed based on its dot-plots.
The elevated inflation levels are also likely to continue put pressure on the long end of the curve, evidenced by how the US-10 year and US-30 year were above 2% and 2.4%, respectively, prior to the Fed’s March meeting.13 But the movement in the long end will not be as great as the increase in the short end, leading to a bear flattening scenario – the base case we outlined prior to the invasion and in our 2022 market outlook. This would be a continuation of the current trend, as shown below.
US 10 Year minus US 2 Year Yield (%)
This derivative impact of the war spiking inflation, at a time when the overall economy continues to heal and rebound from the pandemic, is more intuitive. Rates are likely to go higher as the central bank tries to cool inflation.
And, right now, it seems that the Federal Reserve put (i.e., the Fed shifting policy to be accommodative in times market stress) is still out of the money, even with the market down double digits on the year and some segments in bear markets.
To mitigate the impact of higher rates, seek real income and consider:
- Senior loan exposures that actively manage credit selection within the below-investment grade floating rate senior loan market: SPDR® Blackstone Senior Loan ETF [SRLN].
- Investment Grade Floating Rates that seek to offer exposure to this precise floating rate market: SPDR® Bloomberg Investment Grade Floating Rate ETF [FLRN].
- Ultra-Short active strategies that in addition to owning investment-grade floating rate debt also allocate to higher yield corporates as well as securitized credits (ABS, MBS, CMBS): SPDR® SSGA Ultra-Short Bond ETF [ULST].
Why Make Tilts in Today’s Uncertain Market
The distressing events we are witnessing in Ukraine have led to significant market dislocation, with currency, stock, and bond volatility increasing. With so much uncertainty ahead, there is much that feels out of our control.
Diversifying portfolios to address the current market risks of volatility, inflation, and higher rates may help you to stay focused on long term-goals in an environment where that seems increasingly difficult to do. Diversification is just one of our four best practices for managing volatility.
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