Ukraine crisis – Key questions answered


Will the events trigger a global recession? In our view, the first-order effects of the crisis are not likely to be large. Russia and Ukraine only account for 2% of global GDP. Provided sanctions stop short of limiting purchases of Russian energy, their global economic impact is also likely to be limited. As such, we do not think the conflict itself is likely to provoke recession.

However, risks have clearly increased with respect to second-order impacts: One second-order effect is what higher commodity prices do to growth.
Brent crude is up over 12% so far this week, taking it over USD 100/bbl. Oil prices could gain further if the conflict persists, especially in the event of disruptions to supply and/or potential sanctions that limit Russian exports (although this is not our base case). We estimate that if Brent prices remain above USD 125/bbl for a period of around six months, this could shave up to half a percentage point off global growth this year. This, however, is not enough to reverse the broader recovery from the pandemic.

Another key second-order effect is what higher commodity prices mean for monetary policy. We continue to expect the Fed to hike rates in March and think central banks will not view these events as long-lasting. However, if we were to see a wage-price spiral starting emerge, potentially as a result of higher commodity prices making inflation more persistent, the Fed could enact more aggressive hikes thereafter. So far, the market appears to be pricing in the former scenario as more likely, moving from 6.5 Fed rate hikes by the end of the year to just under six rate hikes. At the time of writing, 5-year, 5-year forward inflation swaps (a measure of long-term inflation expectations) have moved from 2.36% last week to 2.46%.
Overall, the probability of recession has risen because of recent events, but we still see it as unlikely and do not expect it to materialize in our base case.

Should I sell now?
Market timing is always difficult, particularly when it comes to uncertain geopolitical dynamics, but history tells us that the best course of action is to stay calm, patient, invested, and diversified.

Market drawdowns typically don’t last long: Since 1945, markets have spent only about 14% actively falling and 86% of the time recovering previous losses or breaking through to new all-time highs. And drawdowns based on geopolitical events have been particularly brief: If we look at S&P 500 performance following key military conflicts since 1945, markets were usually down within the first week, but on 14 of the 18 occasions they were up within three months with a median performance of around 2%.
At this stage, sentiment is already poor, with the American Association of Individual Investors’ bullish sentiment survey close to its weakest level since 016. Valuations have already dropped. And despite the clear increase in uncertainty, above trend global growth as countries lift COVID-19-related restrictions could make the outlook for stocks more favorable.
Of course, this does not exclude the possibility that markets could fall even further in the near term. An escalation of events in Ukraine, heightened concerns about the geopolitical read-across to other regions, and the implications for the economy and monetary policy could all add to risk premiums.
That said, if a downside scenario does materialize, it is important that investors retain a longer-term perspective. Going back to 1945, the average drawdown for a balanced portfolio has only lasted about 2.5 years, and the longest was only just over four years, so provided investors remain patient during such periods, better returns have always come through eventually, and bear markets can prove to be good times to build up exposures for the long term.
Where are the safe havens?
Many classic “safe-haven” assets have performed well, including US Treasuries, the yen, the Swiss franc, and gold. But while these assets may continue to outperform in the near term, we see better ways of building defensive exposure into portfolios at present.
We like the US dollar, which typically outperforms during geopolitical crises, and has done so again. The DXY index is up 1% following the Russian invasion. Going forward, we also think the dollar should be well-supported by central bank divergence, with the Fed on track to raise rates faster than the European Central Bank.
Another way to build some defense into portfolios is to add to more defensive sectors and strategies. Global healthcare is our preferred defensive sector (though we expect US healthcare to trade in line with the rest of the US market). The ex-US sector has a higher exposure to pharma (at 61%), a defensive subsector, and in our view benefits from a stronger dollar given relatively high sales exposure to the US.
We also see dividend strategies, dynamic allocation strategies, and the use of structured solutions as potentially attractive means of improving the risk-return profiles of overall portfolios. In particular, during periods of elevated volatility investors can earn high yields with volatility-selling strategies, provided they are willing to tolerate the risk.

Other perceived safe-havens, such as gold, the Swiss franc, and US Treasuries are unlikely to perform well in our view. We also do not favor crypto coins as a safe haven. While the latest crisis has underlined gold’s insurance qualities, we continue to expect a drag from higher real rates and a stronger US dollar later in the year. The Swiss franc is also a sub-optimal hedge, in our view, due to its exposure to the European economy, which would be impacted if energy supplies are interrupted. Longer-duration US Treasuries still offer unattractive yields, and with central bank rate rises imminent, we don’t expect a sustained rally in the 10-year US Treasury.
Bitcoin, meanwhile, has failed as a safe haven in this crisis, falling as the situation has escalated. It is currently trading around USD 35,000, 6% lower on Thursday at the time of writing, and is down 40% so far in 2022.

How can I hedge a portfolio?

There is no one-size-fits-all hedge for investors, and while volatility remains elevated, buying outright protection for equity positions can be expensive.
But by keeping portfolio principles in mind investors can help shield overall portfolios from volatility.
Diversification is a good overall hedge for portfolios. By diversifying across regions, sectors, and asset classes, investors can reduce their exposure to idiosyncratic risks related to the crisis in Ukraine, or to other emergent political risks around the world. This is particularly important when we consider how recent events could magnify geopolitical risks elsewhere in the world. Consider, for example, the potential effects of high commodity prices on general civil unrest.

Commodities can be an effective specific hedge today, given the potential for a disruption of supplies from Russia and Ukraine. Russia accounts for around 40% of the European Union’s gas imports and 30% of its oil imports and is the world’s largest wheat supplier. Ukraine is a material exporter of corn, wheat, and oilseeds. Amid the risk of supply disruptions, we think broad commodities can be an effective geopolitical hedge for portfolios, as well as offering an attractive source of returns in an environment of accelerating growth, inflation risks, and higher rates. We think that longer-dated commodity contracts are a good way to gain
exposure to commodity markets, with lower volatility than in the shorter-term contracts.
We also like energy equities. After a strong start to the year, we note that the performance of energy equities has recently begun to lag that of the oil price. Part of this is due to the market not expecting current high oil prices to persist, and part may be due to idiosyncratic risks posed by the conflict to some oil & gas producers. However, overall we would still expect energy equities to rise in the event of an escalation in the conflict, and in the event of continued strong demand for oil as countries lift COVID-19 restrictions.
Investors can also consider adding alternatives within portfolios, including allocations to hedge funds, private markets, global direct real estate, and structured investments. Hedge funds have outperformed stocks in most years that equity markets have fallen over the past two decades.
Private markets also have a low correlation to public markets, offering diversification benefits. Furthermore, in an environment in which inflation is perceived as a threat to markets, the correlation between equities and bonds may rise, increasing the value of alternative assets from a diversification perspective.

Should I sell investments in Russian stocks or bonds?
Equities: Reduce exposure to Russian equities, diversify concentrated positions
The market has sold off very significantly already, but the looming risks of Western sanctions effectively make the Russian equity market uninvestable in our view.
For the names that are affected by owners being added to the OFAC SDN list or similar lists, history suggests that losses can be significant. While we think the West will try to avoid interrupting energy and commodity flows, it will now likely consider adding more sanctions on companies. History also suggests that sanctions against Russian companies will remain in place even if this becomes a “frozen conflict” in the future.
Where investors are already well-diversified globally, the scale of Russian equities in portfolios is already relatively negligible—MSCI Russia accounts for 1.9% of the MSCI Emerging Market Index, which itself is only roughly 11% of global equity markets. As such, even though there might be upside in Russia equities on a 3–6-month horizon if the crisis were resolved, the potential benefit does not offset the risks and potential complexity.
For investors who have concentrated single security positions in Russia, or above target-weight exposure, alternatives to invest include areas we like such as commodities or cybersecurity.

Bonds: Underweight Russian credit
We have recently downgraded Russian credit to underweight from neutral in our Top Emerging Markets Bond List. Our downgrade of Russian credit is linked to its less attractive risk-return outlook, given the latest developments, as any further sanctions could have direct implications for Russian bonds.
The sovereign and the companies we cover have entered this period with existing buffers in place. The Central Bank of Russia has already introduced several measures to support the banking sector. It has said that further measures to support financial stability will be introduced if required. We note that the issuers under our coverage have a long history of servicing their external debt in full and on time.
However, we expect to see an ongoing deterioration of the financial and operational performance of Russian credit issuers. Hence, we expect negative changes in the credit ratings of some issuers from the rating agencies, which may lead to the loss of their investment grade status in some cases.

We have moved select Russian bonds to expensive with some other issuers under review. Western governments have stated that they would add further names to the SDN or similar lists, which will likely require us to stop providing recommendations on affected Russian names, if any, under our coverage.
History suggests that when securities trade at deeply distressed levels, investors typically get a time window to sell their exposure, but they will face significant losses. History also suggests that affected issuers could later be granted a waiver to pay their debt if they want to.

The ruble: Higher risk premium to persist
After staying stable for the first half of the week, the ruble has come under severe pressure following Russia’s military strikes against Ukraine, with USDRUB currently trading at 84.09. Earlier this week, we shifted our USDRUB forecast to reflect further RUB weakness in the near term and indicate that a higher risk premium will remain priced in over the coming quarters. Our end-of-quarter USDRUB forecasts are 83 by 1Q22, 80 by 2Q22, and 78 for 3Q22, and 78 for 4Q22 (from 78, 74, 73, and 73, respectively).

Is this a time to buy the dip?
Volatility is likely to remain high in the near term, and so we cannot rule out the possibility of further downside for global markets. However, in our base case we do not expect this downswing to last, and note that over the longer term, geopolitical events have tended not to have a major bearing on market returns.
For investors looking to build up exposure at his time, we would recommend focusing on the following areas: We still expect the winners from global growth to outperform. Economic
and earnings fundamentals remain strong globally, as restrictions are lifted and companies replenish depleted inventories. Provided Russian energy supplies continue to flow, we believe Europe will be among the main beneficiaries from the robust global backdrop, especially given undemanding equity valuations. Energy equities are also a key winner from
stronger global growth. The sector has the additional advantage that it is well-placed whether our risk case for Ukraine emerges or if tensions subside. Even in the event of a deescalation, oil supplies are likely to remain limited after years of underinvestment in production capacity, while we also expect a recovery in crude demand to pre-pandemic levels.

China stocks look attractive versus peers in Asia, and from a diversification standpoint. China’s equity market underperformed global markets last year, with MSCI China falling 22.8% versus a gain of 16.8% in the MSCI All Country World Index. But we expect the macro slowdown to bottom out by April, helped by a significant easing of monetary policy by the People’s Bank of China. This should contribute to a stabilization in the earnings outlook for Chinese companies by the early summer, and the consensus forecast is for 14.7% earnings per share growth in 2022. While volatility remains a risk for China’s tech companies, we believe the worst is likely over from a regulatory perspective, and China’s market is also relatively well insulated against current global interest rate and geopolitical risks.
Among longer-term investments, cybersecurity looks well-placed, with cyberattacks associated with the conflict underlining the need for more spending on defensive measures by companies and governments around the world. According to the 2021 Norton Cyber Safety Insights Report, nearly 330 million people in 10 countries have experienced cybercrime in
the past 12 months, spending 2.7 billion hours dealing with the aftermath.

Greentech stocks have underperformed in recent weeks, partly due to concerns about the impact of higher interest rates on valuations, but we see them as attractive both tactically and structurally. In the near term, high commodity valuations and a heightened focus on energy security are likely to boost focus on the sector. Structurally, the sector should benefit from
growing pressure for economies to transition to net-zero carbon emissions.
We see opportunity across greentech, clean air and carbon reduction solutions, as well as in carbon trading strategies and ESG leaders.
The ABCs of tech—artificial intelligence, big data, and cybersecurity—are all supported by secular trends, and tech companies have recently been falling due to higher rates. While it is not possible to pinpoint the perfect time to buy, these industries look attractive over the long-term in our view, and as such as potential candidates for investors to buy during periods
of volatility. We expect our ABCs of tech theme to generate 10% annual revenue growth and 16% annual earnings per share growth over 2020–25 on average.

Should I buy now or wait?
Selecting the perfect time to enter the market—or exit—is notoriously difficult and building exposure during a geopolitical crisis can seem daunting, especially given the potential for further losses. But at the same time, it is often during periods of volatility when investors can make the best longer-term investments, and there are certain strategies that can
reduce the risks from buying dips: Phasing into markets can help lower the timing risks, especially when putting large sums to work. Investors can consider also adding exposure
first to less volatile assets, such as defensive sectors like the pharmaceutical industry, and later phasing into more volatile assets. We believe the best strategy is to establish a set schedule, and to accelerate each phase-in tranche if there is a market dip of at least 5%.

A put-writing strategy enables investors to earn a premium by giving others the right to sell them a security at an agreed-upon price—typically a discount to the current market price. If the market does not fall, the option expires worthless, and the put writer keeps the premium. If the market falls, the put-writer—who had been intending to increase exposure to equities anyway—ends up taking delivery of the stock. While this strategy is not without its drawbacks, it can mitigate the drag on returns as an investor gradually enters the market.
As an alternative to option strategies or other derivatives, some investors may be willing to commit their cash fully upfront in exchange for a structured investment that provides some combination of these strategies’ characteristics. For example, some structured investments limit upside participation in an underlying index, in exchange for downside protection, a fixed coupon payment until maturity or other features to adjust the distribution of returns.

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