Our Investment Team Manager, John Genovese, takes a look at potential outcomes of the Ukranian war and its impact on the global economy, and explores the various risks facing investments as financial and global events unfold.
For most of history people have lived with the fear of catastrophe. The bible is full of pestilences and plagues, invasions, famines and wars, to say nothing of divine retribution, all of which threatened mankind itself. In recent times we’ve had world wars, more plagues, millennium bugs, economic ruin, and terrorism to worry about amongst countless other concerns.
As a child I had an awareness that we had Russian missiles pointing at us constantly, ready to be unleashed on a moment’s whim. The great superpowers were locked in a struggle for military and ideological supremacy, and we lived our lives under the shadow of annihilation.
All of that changed with the tearing down of the Berlin Wall, one of the most significant moments in European history. From that point on we suddenly felt more secure, more connected and more optimistic about the future. The internet helped to bring us all together, and we started to see the world as a supportive global community.
President Putin has changed all that. Just when we believed that Covid-19 had been defeated and it was safe to plan ahead once more, Russia’s invasion of Ukraine has taken us back in time by 40 years to a new ‘cold war’ which is likely to go on for the foreseeable future.
These are worrying times, and we wanted to provide an update regarding the situation in Ukraine and address the recent volatility in financial markets.
This is a very complex and fast evolving situation, so it’s worth noting that any commentary can quickly become outdated. Firstly, our thoughts are with the people of Ukraine, and we wish for a quick resolution to the conflict.
That said, we also have a duty to protect and grow our client’s capital, so it’s important to consider the different potential outcomes arising from current events. There appear to be several scenarios that might play out:
1. Peace Agreement
Putin recently stated his terms for a peace deal, which fall into two areas:
(1) Demands that are easy for Ukraine to accept; and
(2) Demands to enable Russia to save face.
Referring to (1), the demands include Ukraine being neutral, and not applying to join NATO (which Zelensky has already agreed to). Ukraine must begin a disarmament process to indicate that it isn’t a threat to Russia. Also, the Russian language is to be protected, and there is to be a process of 'denazification'. Whilst Zelensky himself is Jewish, Turkey believes that if he condemns all forms of neo-Nazism and is strict on it, he should appease Putin.
Regarding (2), Putin stated that he requires face-to-face negotiations for an agreement to be established. The remaining issues have been less explicitly stated publicly. However, they revolve around the status of Donbas, and Ukraine giving up territory in the East. Putin also potentially wants Ukraine to formally agree that Crimea belongs to Russia, although Russia has no legal claim to these lands, and they signed an international treaty (prior to Putin being in power) whereby they accepted that it belongs to Ukraine.
These are likely to be highly contentious, and a bitter pill for Ukraine to accept. However, it is possible a peace deal can be agreed, even if this does take a prolonged amount of time. There is still the possibility of an agreed ceasefire in the meantime. Ukraine has suffered an appalling amount of damage over the past few weeks and will require a large amount of time to rebuild. However, the rest of the global economy should look to stabilise in the instance that this occurs.
2. War Ending by Force
It is possible that once Putin’s army has consolidated their initial targeted gains, he ceases attacks elsewhere across the country. The Russians could neutralise the apparent military threat of Ukraine and force the country into political change. This outcome would unquestionably be distressing for the Ukrainians, but financial markets would likely rebound relatively quickly.
3. Prolonged Invasion
It was initially believed that Putin was too intelligent to lead Russian troops into a scenario whereby they are stuck fighting Ukraine for a prolonged period lasting months or even years. Such disastrous circumstances were witnessed by events led by America in Afghanistan and Iraq. Moreover, Russia even undertook similar military missteps in both Chechnya and Afghanistan.
The probability of this occurring has increased of late. This is due to the strong Ukrainian resistance and the support received from their allies. If it is prolonged, then the likelihood of a critical mistake will also increase. This would give rise to a constant element of high risk and volatility, which financial markets have begun to price in. This has led to decreases in valuations, which are more consistent and widespread than before the invasion. If this develops further, then it would be detrimental for Eastern Europe, although it is likely that financial markets would become adjusted, and lose focus on it over time. This would lead other global trends to continue to dominate the direction of financial markets.
4. A Major Global Conflict
Due to the likelihood of a misstep increasing, we must understand that tensions around the globe have risen to the highest level in decades. This possibility has not yet been priced into the markets. Whilst it is unlikely that circumstances will escalate to this level it would be a matter of great concern if they did. Also, in this event it is possible that the war would spread past Ukraine to include NATO. The West have made it increasingly difficult for Putin to seek an easy way to withdraw from this situation, increasing the risk further. It is possible that Putin has ambitions far greater than that of just Ukraine. This would result in major difficulties across global financial markets. However, his offer of terms for brokering peace make this appear to be unlikely at present.
5. Political Upheaval in Russia
Economic sanctions imposed on Russia by the West are likely to have a heavy toll on their economy. The economic pain might give rise to some degree of meaningful opposition to Putin and his policies. There is the potential for this to pose a serious threat to his regime and even force him out of office. This might grant NATO countries the potential to foster a new relationship with Russia and in doing so stabilise the global economy.
Russian Investments
In terms of your investments, our recommended fund managers have full autonomy when it comes to managing their portfolios of assets and securities. Regulations rightly prohibit them from making investment decisions based on the influence of third parties.
In reality, the relatively small size and well-documented issues in placing and holding investments in Russian assets have been a disincentive to professional and institutional investors for a number of years now, and any exposure to Russia through, for example, a global equity or bond fund is likely to be tiny. Nevertheless, during recent meetings and regular email communications with the fund managers that we use within our portfolios, we have requested and received assurances that where exposure did exist and positions could be readily traded, they have sought to remove them in response to current events.
Inflation
Perhaps more concerning to most of us in our daily lives is the impact of rising inflation, including significantly higher energy costs, which has been the primary reason for the decline in asset values since the beginning of the year.
Property and share prices are a function of future expected cashflows in the form of dividends and rent, and if consumers are spending more on food and electricity there is less to spend on other goods, reducing demand and dampening growth.
The combination of a strong economic recovery fuelled by central bank stimulus programmes and the recent price shock across commodity markets has led to higher-than-expected inflation and a higher probability of it persisting for longer.
Higher energy and food prices are at risk of lowering consumer spending, unless wage increases can keep pace and/or accumulated savings/credit be used to bridge the gap. Furthermore, increased costs for businesses can squeeze profit margins, leading to lower growth across areas of the equity market which don’t have sufficient pricing power to pass higher costs onto their customers. This, combined with a higher cost of borrowing for companies as central banks raise rates, heightens the risk of stagflation taking hold, or even a recession as events develop.
It is normal for share prices to readjust downwards in such circumstances, but as businesses adapt to conditions their margins and profits will start to rise again, leading to higher future share prices.
With bank base rates at only 0.75% and inflation over 6%, it’s a fact that investing in real assets remains the only effective way to ensure that your portfolio maintains its value in real terms, notwithstanding the rocky path on the journey. We don't claim to be able to predict the future, but we do know that, despite the ups and downs, investors who stay the course have reaped far superior returns compared to deposit accounts over every rolling 10 year period since WW2.
Our model portfolios are designed to withstand changing conditions, as we diversify across multiple asset classes, sectors and sub-sectors, many of which generate returns which we would expect to benefit from higher inflation. Within the equity portion of our portfolios, there is diversification across investment styles, but with a bias to quality.
Key attributes a manager will look for in a quality company include having a strong market position, unique/protected products and services, strong balance sheets with less reliance on corporate borrowings/debt and high margins, cash generation and returns on capital re-invested. These attributes typically better equip these companies to continue to perform well on a relative basis during a period of rising prices/costs.
Valuations of companies with these characteristics are also now looking attractive, as many of these companies have endured a re-rating over the past 6 months while the market took profits from these investments and reinvested them into cheaper, more economically sensitive companies, such as financials, energy and miners, to chase shorter-term gains.
We take a great deal of care in our investment selection process and continue to review our portfolios regularly. Our approach is to begin with the asset allocation decision based on our standard templates, and to adjust these to reflect our view of conditions. We will then focus on the specific investment funds and managers that we consider are best placed to deliver the required results within each asset class, going through a number of criteria before they are recommended for inclusion. Changes are intentionally made infrequently, firstly to reduce trading costs but also to allow time for investment themes to emerge.
Risk of Recession
Whilst the risk of a future recession has increased, it is also possible that headwinds to the global economy abate in time to avoid this scenario. If it were to occur, then our portfolios include investments which have historically held their value much better than equities, which tend to be more volatile when sentiment is low.
During past recessions, our regular rebalancing process has meant that more of these lower volatility assets have been sold, with the proceeds being reinvested into equities which have fallen in value due to ‘risk-off’ sentiment. Experience tells us that this process then leads to higher returns going forward, as equity prices inevitably rebound and portfolios are exposed to a higher proportion of units bought at lower prices.
Whilst it is tempting to believe you might be able to successfully ‘time the market’, by selling everything at the top and buying it all back at the bottom, history suggests otherwise, even for professional investors like ourselves. Our experience over several decades is that remaining fully invested is the key to generating good longer-term returns.
As an example, the return on the FTSE 100 index, which represents the largest 100 companies listed on the London Stock Exchange, over the past 15 years is around 5.5% pa at the time of writing. If you exclude the best 10 days of market performance, this return falls to around 1% pa. Trying to guess when those 10 days of superior performance might occur within a 15-year time-frame doesn’t come with a high probability of success. Our strategy remains to take a long-term view of investing, look for high-quality holdings, and keep faith through the inevitable periods of difficulty. This approach has worked well for our clients over many years and we see no reason to deviate from it now.
Conclusion
The circumstances surrounding the Ukrainian invasion are deeply concerning and we hope the situation improves in a rapid manner. This should enable the country and its people to recover and start to rebuild their lives. Our hope is that that a peace agreement can be established, and the global economy begins to stabilise. But whatever the state of the economy and the geopolitical back-drop, you can at least rest assured that our model portfolios are constructed with all potential scenarios in mind to ensure you remain on track to achieve your longer-term goals.
John Genovese
Investment Team Manager
24th March 2022
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