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Natasha Brook-Walters - Director of Investment Strategy
We are deeply saddened by the news that Russian President Vladimir Putin has launched a full-scale assault on Ukraine, given the loss of life and destruction this is already causing. As we turn from the humanitarian concerns to focus on the longer-term implications for markets and asset pricing, we wanted to share with you two Wellington perspectives that the Multi-Asset Platform found helpful as an input to our investment process and discussions yesterday, along with Adam Berger’s and Nick Samouilhan’s initial thoughts. The Multi-Asset Platform is focused on shifts in probabilities and what reactions from Western governments and central banks could mean for longer-term asset performance. The situation is highly fluid and how it develops from here will be critical.
Gillian Edgeworth - Macro Strategist
Putin has signalled that he wishes to replace the current Ukrainian government with a pro-Russian administration. This implies ongoing military conflict until the Ukrainian government steps down and much of Eastern Ukraine is secured. Even if Russia succeeds in this, we would expect persistent pockets of resistance.
What does the escalation of sanctions look like from here? Below is a rough guide. My conviction in the first set of steps is high. Beyond that, the potential costs to the West increase, but I believe these countries’ willingness to absorb these costs is much higher than in the past.
At the time of writing, the UK and the US have already announced additional sanctions, with the EU and others to follow shortly. The US sanctions involve the following:
Our legal team is working through the details of these items as we speak.
John Butler - Macro Strategist
The current escalation could have a significant adverse impact on European economies in particular, with the global economy and central banks facing a double whammy of higher inflation and lower growth. The impact of gas and oil prices so far could already add 1% - 1.5% to inflation and could lower growth by 0.75%. The aggressive ratcheting up of sanctions is likely to have an additional blowback on to the European economies, while consumer and business confidence may be dented by the fear of war.
There is no urgency for the European Central Bank (ECB) to clarify its position on rates as no one expects an imminent rate hike. But I think this will make the ECB even more uncomfortable at this stage with open-ended quantitative easing (QE). I therefore expect it to shift to some form of rolling assessment of QE that enables it to react when it has more clarity, with June as the likely re-assessment date. However, this is a fluid situation.
The impact could be greater for those central banks expected to hike imminently. Notably, the Bank of England has a difficult balance to strike, with inflation already high and about to lurch even higher. While I still expect further rate increases, the pace could be more cautious than the market currently assumes.
The relationship between central banks and growth has changed. During the past 15 years, any negative shock to growth or spike in uncertainty has been a reason to add more liquidity, as the central banks saw little risk of inflation. This time, inflation is higher at the outset, so there is a debate about whether this shock will be inflationary or deflationary over the medium term. If inflation expectations get dislodged, central banks will have to keep hiking into weaker growth. On balance, however, I think central banks fear recession more than inflation. So, while they remain in tightening mode for now, they are unlikely to tighten as aggressively as expected before this shock, even with higher inflation.
The key point is that risk assets no longer enjoy the same level of “insurance” from central banks as in recent decades. Instead, central banks may become a source or even a compounder of volatility.
For most of my career since 1999, I have taken a structurally negative view of the euro area because of its unwillingness to resolve the flaws within the currency union. Every time growth slowed, these flaws risked being exposed. And the only outcome was more and more QE from the ECB. The risk is that this invasion of Ukraine puts the spotlight back onto the outstanding fragilities within the system: from the lack of security (the EU’s dependence on the US) to the weakness of its border controls (migration flows) and its dependence on external energy (in particular, Russian gas).
There must now be a high chance of a wave of refugees from the Ukraine to Poland, Romania, Hungary and possibly euro-area countries. We know the strains this put on European countries in the recent past and how fragmented their response was. This could have negative implications for the region’s politics. For example, immigration could suddenly become a big issue heading into the French election this April.
One possible silver lining to this cloud is that I think there is a higher chance now that this emergency is used to unify the region and define why it exists. The medium-term scenario is that the conflict becomes another reason to accelerate fiscal spending on renewable forms of energy, to remove the euro area’s dependence on Russia. But it could also spark more fiscal spending on everything from rearmament to income subsidies to offset higher energy costs.
Over the past year, my views have changed to become the most bullish I have ever been on the structural outlook for the single currency, motivated by the shift in German politics. My sense is that the German attitude has changed to allow Germany itself to inflate and to be open to explicit burden sharing across the region. That significantly increases the probability that the region is heading towards a sustainable currency union (and one that is no longer unable to create inflation).
So I think this shock potentially changes things. The past 10 years have been characterised by institutional paralysis within the euro area, with fiscal austerity offset by huge liquidity from the ECB. This meant negative rates, low yields and tight spreads. But this event could force clarity on which tail wins — unification or fragmentation. Unity would mean more fiscal spending, an ability to create inflation and more burden sharing across the region. The implications would not be clear for spreads, but yields would be higher. For now, we may have to work through a period of volatility and put the spotlight back on the fragilities within the euro area before these medium-term implications play out.
While the risks of conflict between Russia and NATO have increased, for now a new form of cold war appears more likely. From a macroeconomic perspective, I think such a new cold war would accelerate deglobalisation, which is one of our core themes, as countries will value self-dependence in their supply chains and energy sources.
I think that will mean big investment, financed through fiscal expansion. One of our themes is that inflation will be determined more domestically than globally. I expect current events to accelerate that shift back to domestic rather than global output gaps. It would also mean that country relative stories will become more important again as central banks are likely to keep their inflation targets but allow greater deviations. The cycle could become more volatile and institutions less secure, which would have to be reflected in higher risk premia in markets.
Nick Samouilhan, CFA - Multi-Asset Strategist
Adam Berger, CFA - Multi-Asset Strategist
First, these actions uproot many of the standing assumptions about the global security, political and economic order and will of course lead to strategic changes — this is a watershed event.
The immediate market implications are complicated and hard to predict given that the incursion is ongoing and it’s not clear what the ultimate objective is or what the outcome will be. But, while events in recent days have escalated much further than expected, this crisis has been brewing for some time (and certainly has been the focus of the market in the last fortnight), so some of this will already be priced in. We focus on three aspects:
Looking beyond the very near term, the key driver for markets will be the impact on the outlook for global growth, inflation and interest rates — all of which are related and were the main focus of markets before recent events. Before the conflict, markets were pricing in a series of rate hikes on the back of strong economic growth and elevated inflation, with markets hoping for a normalisation of rates that would lead to a moderation in inflation without causing a recession. While that soft landing was the hope, the risk of a policy mistake was real. This conflict complicates the outlook and increases that risk. Higher energy prices, along with higher prices for a range of other important commodity exports that will now come under sanction or restriction, will worsen the inflation outlook, particularly if these are used as weapons of war. At the same time, these higher energy prices will join elevated inflationary pressures to create downside risks to economic growth due to lower real consumption. So we are potentially facing a challenging time of higher inflation and lower growth, which in turn makes the rate outlook difficult. There are also second-order effects, adding further uncertainty to the economic outlook. For example, we could see a growing likelihood of further fiscal spending in the US and Europe, especially if focused around energy independence and transition.
Within these parameters, we (for now) think a moderately pro-risk portfolio stance may be warranted, overweighting equities and underweighting duration. Given our time frame of 12 – 18 months and based on what we currently know, that stance seems appropriate even in light of recent events. However, if the outlook for growth were to change, we would need to revisit it. That said, unless the escalating conflict in Ukraine triggers a return to a stagflationary regime similar to the 1970s — which is not our base-case scenario — equity markets may now already have factored in the risks of central banks failing to prevent a shorter-term recession. If that scenario is correct, there is a case to be made for long-term investors to maintain their equity positions and even cautiously start leaning into the headwind. But the time frame matters greatly. We cannot exclude further and more pronounced sell-offs in the near term as the conflict sadly continues to escalate. Areas we think warrant particularly close scrutiny include:
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Source: Wellington Management
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