It is not usually a good idea to change long term strategies on the back of geopolitical tensions but we understand why people might.
- Thursday, February 24, 2022
The first two months of 2022 have been challenging ones for investors. The US Federal Reserve’s December announcement on the reversing of their US$120bn per month quantitative easing programme to end by April and that this tapering will be followed by at least four interest rate rises resulted in bond prices falling and equities being revalued. Added to this concern was the cost-of-living crisis hitting consumers and the escalation in Russian military action in the Ukraine. The actions of President Putin have and will influence them all in some way.
Russian aggression towards Ukraine moved to a higher level on Tuesday when President Putin officially recognised the two self-proclaimed separatist republics of Donetsk and Luhansk within the Donbas region of Ukraine. On taking this unilateral action, he then ordered Russian troops to move across the border as a ’peacekeeping operation’. This action resulted in the West announcing a range of sanctions against Russian institutions and individuals of influence.
On Thursday morning, Vladimir Putin launched a full invasion into Ukraine by ordering the Russian troops that had amassed on all sides of Ukraine to enter the country. The Russian President based this military attack upon his view he could no longer tolerate the ‘threat from Ukraine’.
President Putin authorised in the early hours a special military operation which included air strikes on military bases in Odessa. Russia has suggested that this operation posed no threat to civilians. Despite this assurance six people were killed in the air strikes in Odessa.
In 2014 when Russian troops moved into the Crimea and annexed this part of Ukraine it provoked at the time a range of international sanctions. Since then, Russia has been working to build its capital reserves, become less dependent upon the US$ and minimise the likely impact of future sanctions. It has been reported that Russia has built its foreign exchange reserves up to US$635bn, which is the fifth highest in the world. Its national debt is 18% of GDP which is the sixth lowest. Russia has a budget surplus and does not rely upon foreign investors to cover its government spending. The break-even price for Russian oil was US$52pb in 2021. With oil now trading at US$103pb this energy and commodity boom is adding an extra US$10bn to the Kremlin’s coffers each month. The finances of Russia are in stark contrast to those of many European countries.
Russia has the reserves to tolerate two years of sanctions and could cut off gas supplies to Europe without running into trouble. This position could mean that sanctions imposed by the West could be relatively modest as those that have already been announced have been. The reality is that a series of hard sanctions could hurt the West before Russia. For example, Europe is reluctant to support the removal of Russia from the Swift international payment system as Europe would suffer a more immediate loss than Russia would. The one sanction of note was German Chancellor Olaf Scholz stating he would not certify the Nord Stream 2 gas pipeline. This potential cancellation would have a big impact upon future Russian gas sales to Europe.
‘Fortress Russia’ does have some weak spots that Britain can play a part in imposing them. We could stop Russia from selling its sovereign debt on London markets and cut access to international capital for Russia’s largest companies.
This time last year the price of gas was 40.63 p/therm. Due to the suppression of Russian gas supplies particularly to Europe, natural gas prices hit 451.72 p/therm on 21st December but have now fallen back to 266.69 p/therm. Brent Crude oil prices have now also risen to US$103.36 per barrel, up from US$68.87pb on 1st December. It is this increase in oil prices that has forced up petrol prices to a new record of £149.12 per litre this week.
Both gas and oil prices are at extraordinary high levels and Russian supply levels has been a major factor in this. President Putin is taking advantage of Europe’s dependency upon Russian energy to aid his political objectives. However, Russia does still want to sell oil and gas to Europe as Europe is its major customer. Forty nine percent of all of Russia’s exports are in energy. The loss of trade with Europe would hit Russia but not enough for Putin to hesitate over further military action.
The key risk to investment fundamentals is the impact on energy prices if Russia retaliates to the sanctions placed on it by Western governments by limiting its supply of oil, gas and earth metals. This would impact markets as any price rises will feed inflation and put pressure on central banks to further hike interest rates. Central banks are very reluctant to rise rates but inflation is a major threat.
Over the past year consumer demand has caused inflationary pressure at a time when supply, inventory and delivery was under pressure. Some analysts are predicting that US inflation has now peaked at 7.5% in January. This may result in the Fed easing its stance on future interest rate hikes while the rising levels of geopolitical risk in markets may cause a further re-think over the pace of planned interest rate rises.
The current situation is very worrying but it is worth remembering that often episodes of war or the threat of war do not result in heavy stock market falls. Markets usually discount the risk prior to the event rather than once military action takes place. Both of the US Iraq wars marked the start of a stock market rally as did the US Russian Cuban missile crisis. If Wednesday was a day to go by, markets were more concerned about petrol price increases as a result of the Russian military action than the action itself. However, on Thursday markets fell 3% – 4% on opening with the news that Russia has started its invasion of Ukraine.
Markets have priced in the level of risk and the likely consequences. For example, as at 23rd February, the S&P 500 is down -8.6% over 3 months while the Nikkei 225 is down -9.7%, the Euro Stoxx 50 down -7.2%, and the MOEX Russian Index is down -21.6%. However, the FTSE 100 was up +3.2%. This is due to the perceived undervalue of the FTSE 100 and that it is made up of banks, pharmaceuticals and energy companies, all of which are doing quite well. Investment portfolios are globally diversified and will have holdings across all major regions but we hold nothing in Russia and little in emerging markets. The UK while doing well this year has for the past 11 years underperformed the MSCI world index as others we hold have exceeded it.
Some commentators have suggested that the actions taken by President Putin to recover the Russian speaking parts of the Donbas after Russian supporting separatists took control of the region in 2014 is his objective. A military peace keeping force in Donetsk and Luhansk is not that different to the annexation of the Crimea and similar to the two Georgian regions of Abkhazia and South Ossetia which were also turned into Russian protectorates.
It now looks as if it was wishful thinking on the part of Europe that President Putin would be content with reclaiming Donetsk and Luhansk and that war could be avoided. The US and UK’s military intelligence provided a more hard-line view that military action in the Donbas region was only the start. How quickly was that proved correct.
If Putin stops at claiming Donetsk and Luhansk or something similar, then the West would live with it and Ukraine expected to live with it. Putin will have his victory, embarrassed the West and sanction removed.
Most US companies have published their quarter 4 earnings results and profits were strong. The large majority of S&P 500 companies reported results better than analyst expectations. The outlook for this quarter is however less certain. Beyond the crisis zone, global activity will continue but the risk to energy supply and inflated energy costs are a problem that will impact consumer spending and market confidence.
As previously expected, the yields on US treasury bonds have risen above 2% following the inflation rate figures for December hit 7%. Markets now are expecting not 4 but 7 interest rate rises this year from the Fed as it tries to curtail inflation.
The current falls in equity values could be short lived if history is to be repeated in these situations and if in time a resolution is found that protects and strengthens Russia’s position then a recovery rally may well develop as global business expands.
Our portfolios are rebalanced every six months with a view to assessing opportunities and risks over the coming six-month period. Our general asset allocation does not focus on predicting world events but some of our stock selection would do so. The Edition 36 has holdings in gold, commodities, cash and gilts to protect against uncertainties. Our bond holdings are in short dated credit or index linked credit to protect against inflation. We have exposure to floating rate bonds as a protection against rising interest rates. We hold diversification in property, infrastructure and insurance markets to access returns from a wide range of sectors. We hold hedge funds in both equity and bond markets to limit volatility and spread our asset mix. These were conscious decisions made as we expected uncertain times. We are not heavily exposed to the outcome of any one particular event including this conflict in Ukraine. We are however invested in markets that are sensitive to events.
We are acutely aware that our portfolios are down in value this year and that our passive Beta portfolios have performed better than our active Alpha portfolios. This has been primarily a result of us being overweight in US growth stock, Tech stock and Green Energy stock. All of these sectors have been hurt by the expected rise in US interest rates. These sectors have provided the greatest source of growth in our portfolios for the past decade but this year have suffered.
I have eased our exposure and moved to some more value-based stock in the latest Edition 36 but still believe that these sectors offer very good long term returns and that converting a paper loss into a material loss is not good investment practise. Our last one month returns since our rebalance took place in early January has seen all of our portfolios do better relatively to their respective national averages. In truth, we lost less than the national averages.
If clients are nervous, please talk to us. We can make any changes you may wish. It is not usually a good idea to change long term strategies on the back of geopolitical tensions but we understand why people might. We have built a defensive portfolio for these circumstances that is available to investors if they want to change their positions. We have a feeling that this conflict is now not likely to be resolved soon.
Chris DaviesChartered Financial Adviser
Chris is a Chartered Independent Financial Adviser and leads the investment team.