Ukraine crisis: multi-asset views


Amid the ongoing tragic events unfolding in Ukraine, Schroders will be publishing articles and videos that examine what has happened, and review potential scenarios and market implications. Read more here: InstitutionsAdvisersIndividuals

Video transcript

Overview of conflict

Well, first and foremost, the conflict right now is a humanitarian issue. So our hearts go out to everyoneone affected. I really hope the conflict ends soon. But in terms of what's driving the conflict, we do have two opposing red lines that both parties can't seem to cross.

One is Putin does not want Ukraine to be militarised and does not want them to join NATO. On the other side, you have Ukraine that wants NATO membership and wants to have the ability to defend itself against its neighbour, Russia. So unless either of them give up on those red lines, we're not sure if a diplomatic solution can be reached right now. Although overnight they did have a meeting at the Belarusian border, and delegates from both sides discussed how a ceasefire could come to fruition, nothing has been agreed upon yet. So right now, there's nothing we can see that could stop the war from a negotiation standpoint. We'll have to see how the war plays out. It could be a drawn-out event for now.

What we're seeing is increasing tensions more globally as well. Russia has upped the ante by giving its nuclear arms sort of a high level of alert to potentially be used, which is obviously a disaster if that occurs. Neighbours like Belarus have actually changed their constitution to allow Russia to put nuclear weapons in their country, which borders Poland and NATO. And you're seeing an upheaval of the last 50 years of geopolitics. So countries like Germany and Japan who have typically been more pacifist since the war, WWII, have now become more militaristic. Germany has increased its military spend overnight, Abe-san of Japan, the ex-prime minister, has discussed potentially putting US nukes in Japan. We're seeing these things change, and also neutral countries like Switzerland and Sweden have actually become non-neutral in this debate. It's a real up-ending of the geopolitical stability of the past 50 years.

Government reactions to the conflict

For right now the West itself can't retaliate militarily by having boots on the ground because Ukraine is not a NATO member yet. They have to station their militaries on the border in cases it spills over into NATO countries, but they are providing military aid and training etc. But in the meantime, they’re using financial sanctions to really help punish Russia.

There was a whole lot overnight, but the two main ones first of all were removal of SWIFT access for certain Russian banks. And that means those banks cannot access foreign currency via transactions by not being on that platform. Although right now we don't know which banks, how many banks and currently oil and gas trades are relieved from those sanctions. The US still want, well the West still wants energy to flow through, so not sanctioning those trades right now.

But I guess a bigger issue is they've actually sanctioned the central bank, which is quite unique. So the central bank had built up a lot of FX reserves, in anticipation for something like this. So typically, when the currency weakens, they can then defend the currency by selling their FX reserves. But around 50% of those are in European bonds, which the EU have said they cannot sell anymore. So there's not really that liquidity that Russia would need to defend its currency, despite having quite a lot of FX reserves. That's quite a big development right now in the sanction regime.

Implications for the Russian economy

Right now, it's hard to know the exact impact on the economy, but what's occurring in their markets is quite substantial, which normally has a flow-on effect to the economic performance. So if you think about their currency, it's fallen almost 30% since the start of the year. Which is quite a large devaluation, we think more is going to occur on that. You've also seen, although the stock market's been closed since the conflict, if you look at the foreign listed companies, like Gazprom or Sberbank, two of the largest positions in their index, they've fallen between 70% and 90% since the start of the conflict. You've also seen default swaps on the government bonds show a 57% probability of default. So a lot of market indicators are not looking good for the Russian economy.

You've seen the central bank step up, I mentioned before they can access their reserves to defend the currency. So they’ve increased interest rates from 8.5% to 20% overnight, in a way to help the currency. But all these things will have an impact on the economy. So increased interest rates will hurt the economy. Falling currency will lead to inflation and all these things will have a negative impact. So what they're trying to do now to stem that is not allowing foreigners to sell Russian assets. They're saying that they shouldn't pay dividends to foreign held companies. So if you're an investor in the US or UK, you won't get those dividends. In a way that might help stem some of the capital outflows. But it's more of a retaliation to the West in many ways.

So right now we think they're stuck in an economic hard place and it's really starting to pinch them where it hurts. So that might be one of the levers they have to renegotiate if those two other lines aren't agreed upon.

Impacts on global markets

Well, I guess the first point of call is will there be any contagion across other countries based on the Russia situation alone? And it's probably too early to tell. I mean, it was a very fast, violent move in Russian assets and now the central bank won't let you sell those assets. So there’s illiquidity now as well, and there are certain European banks that have a large exposure to Russian assets. So right now those assets might be written-down and they can't be sold because they're illiquid. There might be contagion effects flowing through the global economy, based on those assets repricing that we have not yet heard about.

More broadly, because of the impact on commodities, commodities have rallied very strongly given the war news, that will push up inflation globally. So right now, inflation expectations have been very, very high over the past couple of months. They're unlikely to abate because of this, at the same time, global growth might actually start to come off. So central banks, like for example, in the US the Federal Reserve, are going to be stuck in a hard place now. Do they want to hike rates aggressively to stem inflation, at the expense of the economy rolling over? Or do they want to support the economy by leaving rates low, in which case inflation can continue and maybe even run away and become unanchored? Until we have an understanding of what the policy reaction will be to this inflation, it's kind of hard to understand the global macro impact, but obviously you have a larger possibility of negative events given the situation.

Multi-asset portfolio positioning

We went into this pretty well positioned, I mean, we have very limited exposure to Russia itself, less than 0.1% in government bonds, about 0.05% in Russian equities via the standard emerging market index future. We do actually have short Russian Ruble exposure put on before this, so ultimately, very, very minimal exposure to Russia itself.

So more broadly, how are we positioned for the broader macroeconomic impacts? We have been reducing risk from the beginning of this year. Effectively our main worry was inflation and how central banks will react to that inflation. So we have been reducing equities and credit since the start of the year. So from the peak of our allocation at the end of last year in equities, we reduced equities by about 13%. And we've also reduced our credit exposure by about 8%. And importantly, we currently hold no global high yield in the portfolio. So large de-risking of risk assets before the current crisis, and we’ve been increasing our defensive positioning. Our duration in the fund was around 1 year, we've now increased to 1.75 years, so almost doubling our duration or government bond exposure in the portfolio. And also increasing our currency position to act as a hedge. So we bought more Japanese Yen, which it does well in risk-off, and we have also shorted the Euro because we think if this spreads out beyond Russia into the European Union, the Euro will be one to suffer.

Increasing defensiveness overall, we think while there's a lack of certainty of how this is going to react, the conflict, inflation and central banks, we want to have cash in the portfolio. So we do have higher levels of cash than usual to deploy if any opportunities arise, when in the meantime to sort of damper volatility. In the meantime, some of our allocations to more, we call them diversifying assets, things like private credit, insurance-linked securities, those assets don't really move much in these kind of environments, but actually add to your income during that period. So overall, keeping our income positions, reducing our risk positions, but actually increasing our defensiveness at this time. We’re quite happy to stay defensive until we have more understanding of how this is going to play out.

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