With Russia and Ukraine at an impasse, commodity prices are surging and the risk of stagflation increases. Given the challenging backdrop, we remain defensive, liquid and focused on managing downside risk and preserving capital.
Recent news has been dominated by the conflict in Ukraine. This is a humanitarian crisis, and our hearts go out to all who are affected. We hope the conflict ends soon. Clearly the situation is very fluid. Talks at a meeting at the border of Belarus failed and it appears neither side are likely to compromise. Russia wants a demilitarised, neutral Ukraine with no NATO membership. Ukraine has been pushing for NATO membership. Needless to say, geopolitical and economic tensions continue to rise, and the probability of black swan events has risen.
The West has been united in its response, with a growing list of very effective economic sanctions. One key sanction was to disconnect several Russian banks from the SWIFT global payments system, in an attempt to limit access to foreign currency. Russia’s central bank access to their foreign currency reserves held outside Russia has also been frozen. Further sanctions are expected, and global companies are abandoning their Russian businesses and exposures.
Russian economy set to suffer
Clearly this is having a huge impact on the Russian economy. The Russian ruble has fallen significantly from the start of the year. Russia has closed its equity and bond markets and the credit default swaps on Russian government debt is now implying a greater than 50% probability of default. The central bank has stepped in to stem currency weakness by raising official rates from 9.5% to 20%, but they cannot access a large proportion of their reserves to defend the currency while sanctions on the central bank are in place. Russia has also implemented internal capital controls as civilians attempt to protect the value of their savings with the ruble down 26% over February.
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While the impact is clear on the Russian economy, the extent of contagion risks back into Western economies and in particular the banking sector are still unknown. Clearly, ramifications will be felt outside of Russia. For example, there are reports of European banks holding large exposure to Russia which will be facing liquidity issues and potential large write-downs. So far, Russia hasn’t retaliated with curbing commodity exports, but this could have a dire effect on the Western economies, particularly Europe, where Russian oil and gas makes up a substantial portion of their energy supply. The net result has been a strong rally in commodity prices which will likely push up inflation while also potentially slow the global economy, increasing the risk of stagflation.
Central bank policy is now constrained
The events in Ukraine are clearly troubling and significant uncertainty is resulting in significant volatility in risk assets. We do believe the longer-term driver of markets will still be the growth and inflation outlook and importantly the reaction function of central banks, especially the US Federal Reserve. It is too early to tell what impact this will have on central banks’ pace of official rate increases. Will they support growth and let inflation stay elevated and perhaps become unanchored, or will they focus more on targeting inflation at the expense of growth? Central banks have been a powerful tool to steady the global economy in a crisis. Given inflation, their ability and willingness to do so is now probably constrained. The risk of delaying the targeting of inflation and having a larger long-term issue with structural inflation is concerning.
In terms of the Australian outlook, the market has four official rate increases priced into the yield curve by Dec 2022. The RBA kept rates on hold at the March meeting. This was largely expected given they have been talking about remaining patient and seeing the economic data before deciding the course of policy action, combined with the uncertainty around global growth and inflation as a result of the conflict in Ukraine. The RBA Board is committed to its objectives of a return to full employment with inflation sustainably within the target band. There are uncertainties about how persistent the pick-up in inflation will be given recent developments in global energy markets and ongoing supply-side problems. Currently, wages growth remains modest, and it is likely to be some time yet before growth in labour costs is at a rate consistent with inflation being sustainably within the target band.
De-risking the order of the day
Given the backdrop it is clearly a challenging time in markets. The nature of geopolitical events make them uncertain as to timeframes and outcomes, while volatility remains high. As such, we remain defensive, liquid and focused on managing downside risk and preserving capital. As we entered February, we were already defensively positioned. Credit risk premium had compressed considerably through 2021 and as such we were reducing aggregate credit exposure and improving average credit quality. Over the last few months, we have been reducing our global high yield, European credit, securitised credit, and emerging market sovereign debt allocations. These reductions have seen cash holdings increase to over 20%. We will look to add back into credit markets when valuation opportunities present themselves, however at this stage the uncertainty and volatility is keeping us on the sidelines. In terms of specific exposure to Russia as at the end of February, we had minimal exposure (0.02%) via an allocation to the Schroder Emerging Market Debt Absolute Return Fund.
We have also been adding duration risk to the portfolio. We had kept duration at modest levels throughout 2021 as we were anticipating higher bonds yields as central banks raised official rates. During February we added duration by taking profits on a short duration position in shorter maturity US treasuries, as we expected some of the significant pricing of official rate increases to unwind as a result of the Ukrainian conflict. We also added duration to longer-dated maturities in the US to add some yield and to help protect the portfolio from further downside risks.
In terms of currency exposure, we have also added to the long JPY position against the AUD position. This is viewed as a partial hedge in the event of a more extreme risk off. While we haven’t seen weakness in the AUD at this stage, arguably given the strength in commodity prices, we do think it will assist with tail risks.
Overall, we remain defensive and liquid and focused on managing downside risk and preserving capital. We are ready to deploy the cash we have built up but will be patient given the great deal of uncertainly around the conflict in Ukraine, combined with the uncertainty on transition path to more appropriate monetary policy seatings globally. We will look to position the portfolio in a more constructive way when we see the balance between risk and return move more in our favour.
Originally published by Mihkel Kase, Fund Manager – Fixed Income and Multi-Asset, Schroders