Russian dolls

Russian dolls

It’s tempting to attribute the ongoing risk-off move to Russia’s invasion of Ukraine. That’s part of the story but, like Russian dolls, there’s a scenario inside a bigger one, which is inside an even bigger scenario, and so on. Big picture, massive monetary and fiscal stimulus has averted a depression and flatlined both market volatility and interest rates, boosting asset prices. Now, central banks and governments are no longer calibrating their support to emergency conditions but, rather, to more normal ones. This means higher volatility and rates. Geopolitics isn’t helping. Over the weekend, the military conflict appears to have deepened. The West has announced more sanctions, including the selective exclusion of Russia from the SWIFT platform for cross-border financial transactions. Russia and Ukraine will meet today for talks. Longer term, one effect of the conflict could be protracted frictions between Russia and the West. Short term, rising oil/gas/food prices imply higher inflation and downside risks to growth, especially in Europe – making the ECB more dovish again. Global growth should be impacted to a lesser degree. The Fed still looks set to hike rates from March. China should continue to ease gradually. Given the uncertainty, now more than ever global diversification is key.

The pitfalls of market timing: Anyone’s ability – ours included – to forecast geopolitical events is limited. Of course, it’s helpful to go through different scenarios and think in terms of probabilities. But, rather than timing the market around geopolitics, we rely on fundamental research and analysis together with thorough risk considerations. At this juncture, we don’t believe there are sufficient elements to change our outlook. There are upside risks to inflation and, probably, downside risks to growth especially in Europe, which is more sensitive to potential disruptions to energy supplies and oil/gas price shocks. But this could make central banks in the euro area, the UK and elsewhere in the region more dovish once again. We don’t think the global, US and Asian economies are likely to be impacted materially.

The benefits of portfolio diversification: Russia’s military escalation has triggered a rise in geopolitical uncertainty. With so many moving parts, this is likely to continue for some time. This is raising market volatility and has already triggered a broad risk-off move. Markets have a tendency to overreact to headlines and move from one extreme to the other (as we’ve seen in recent days). Diversification across regions and asset classes becomes especially relevant when idiosyncratic risks dominate. A global approach to asset allocation delivers better risk-adjusted returns over time, reducing the portfolio’s volatility to less than the sum of its parts and offering better protection against local risks. And safe-haven assets such as gold can further diversify strategic allocations and help in risk-off episodes.

Here’s why this matters:

Tactical plays: With growth moving past the peak and rates rising off the lows, markets remain volatile. But solid corporate earnings and bond yields that – while trending higher – remain relatively low still support our preference for equities and credit over low-yielding bonds. Emerging markets had a rocky ride over the past year. But activity is stabilising, while longer-term growth and interest-rate differentials vs developed markets remain favourable. Our tactical asset allocation is overweight equities, with a preference for US and emerging market stocks; overweight credit, with a preference for Asia high-yield and emerging market sovereign hard currency bonds; underweight lower-yielding bond markets, such as EUR and UK government bonds, and USD investment-grade bonds.

Emerging stories: Emerging market equities underperformed global markets significantly last year, leaving them attractively valued. As growth conditions improve, especially in China, we expect them to outperform. We recently opened an overweight in the region over global equities. In response to the pandemic, the US government and the Fed deployed vast amounts of stimulus. In contrast, several emerging markets have seen their policy rates rise sharply as central banks responded to high inflation. Having front-run tighter US policy, and with a possible activity rebound now that Covid vaccination is progressing, emerging markets are about to turn a corner. Financial conditions may start easing before long, while they will likely tighten further across the US, the euro area and the UK.

Meanwhile, all eyes on Russia/Ukraine…

Geopolitics all around: The situation in Ukraine is likely to dominate the newsflow and keep volatility high. The central bank of Russia has hiked interest rates to support the currency. Investors will also focus on energy and commodities. Europe looks particularly exposed to rising oil/gas prices, which could further increase inflation and slow growth. Euro area inflation (Wednesday) should continue to rise, with investors likely watching whether this is again mostly due to energy or if there’s some feed-through to core inflation. We do expect an ECB rate hike before year-end, but suspect that an energy shock weighing on economic activity would make the central bank more dovish. In the US, the jobs report (Friday) is likely to firm expectations that the Fed will start hiking rates and shrinking its balance sheet from March. The median prediction is for a nonfarm payroll gain of just under 400,000, a drop in the unemployment rate to 3.9% and, we think, a slight hourly earnings acceleration to 5.8% (still below the rate of inflation). The US ISM surveys and China’s purchasing managers’ indices (Tuesday, Thursday) should reveal resilient US growth and that China’s stabilisation remains tentative, perhaps prompting further easing down the line.

Daniele Antonucci | Chief Economist & Macro Strategist

This document has been prepared by Quintet Private Bank (Europe) S.A. The statements and views expressed in this document – based upon information from sources believed to be reliable – are those of Quintet Private Bank (Europe) S.A. and are subject to change. This document is of a general nature and does not constitute legal, accounting, tax or investment advice. All investors should keep in mind that past performance is no indication of future performance, and that the value of investments may go up or down. Changes in exchange rates may also cause the value of underlying investments to go up or down.

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