Ukraine conflict may be turning into war of attrition

While Putin has recognised that his initial objectives in Ukraine were unachievable, he appears to have little interest in pursuing peace. Instead, he has set his sights on the east of the country. The risks of escalation – both economic and military – remain high. Russia has said it will cut off gas supplies to Poland and Romania, a warning sign that the much larger German economy could be next. Germany and other countries are also sending more heavy weaponry into Ukraine, raising the risk of the conflict spreading. Meanwhile, strict lockdowns remain in place across much of China, further disrupting global supply chains. Equity markets have now started to react to these threats to global growth, with volatility rising significantly in recent weeks. This has been exacerbated by rising interest rates and disappointing earnings from some large companies, including Amazon.

Full steam ahead for rate rises

Government bonds are often described as “risk-free” – but they have not felt like it for many investors in the asset class this year. Fixed income markets have experienced some of the steepest falls on record as central banks signal they will raise interest rates quickly to combat inflation. Despite greater uncertainty about the growth outlook, bond markets are still expecting the Bank of England and Federal Reserve to increase interest rates by another 1.25% and 2.0% respectively over the remainder of the year. Longer-dated bonds may also be pricing in the risk of inflation remaining elevated for some time to come.

Strong mandate for Macron

Emmanuel Macron won a comfortable victory in the recent French election. He is the country’s first leader in over 50 years to win re-election as president while also retaining control of the legislature. The latest data suggests that France faces similar challenges to other developed countries, with growth slowing as the economy grapples with higher costs. France must also deal with reform of its expensive pension system, a source of controversy during the election. However, Macron’s success should help him make progress towards greater political and economic unity across the eurozone. He may find a willing partner in Germany’s relatively new leader, Olaf Scholz, who will be looking for support as the country deals with a potential energy crisis and long-standing questions over its role in European defence.

Portfolio positioning

Recent developments have raised the risk of stagflation – a period of high inflation and low or slowing growth. Within our equity allocation, we have reduced our exposure to Europe and small- and mid-cap companies. At the same time, we have tilted portfolios towards higher quality companies with stronger balance sheets and greater ability to pass on cost increases. We are also increasing the defensiveness of our fixed income holdings, reducing our emerging market exposure and slightly increasing our allocation to shorter-dated UK government bonds. However, given the potential for yields to continue rising, we still prefer to diversify portfolios using alternative assets such as gold, broader commodities and absolute return funds.

Outlook

	Economics	The invasion of Ukraine will result in higher inflation and lower growth, raising the risk of “stagflation.” High commodity prices and continued supply chain disruption could keep inflation elevated in the near term. Savings built up during the pandemic could provide a cushion for consumers against increased living costs. Interest rates are likely to continue to rise.
	Valuations	Global equities have meaningfully de-rated this year and now look more attractively valued on a relative basis. Government bond valuations look relatively more attractive given the sizeable moves we have seen this year but remain vulnerable to further increases in interest rates. Alternative assets including absolute return funds and commodities look attractive as diversifiers.
	Sentiment	Escalating geopolitical tensions, rising inflationary pressure and anticipated interest rate rises continue to negatively impact investor sentiment. Consumer confidence is the weakest it has been for over a decade. Increasing economic growth concerns as a result of China’s response to their latest wave of Covid cases.
	Risks	Further escalation of Russia’s actions in Ukraine. Risk of a faster than anticipated rate of monetary policy normalisation. Threats to global economic growth from the impacts of high inflation and a China slowdown. Further Covid variants and vaccine efficacy.

Asset Classes

Asset classes	Current positioning	Medium term view	Current views
Equities			Russia’s invasion of Ukraine, China’s response to Covid, inflation and rising interest rates have created a less favourable economic backdrop and resulted in higher volatility. Given the greater risk of “stagflation” (high inflation and low or negative growth) we prefer higher quality companies with the ability to pass on higher input costs to consumers. We maintain conviction in long-term, secular themes including healthcare and energy transition.
Bonds			Longer-dated government bonds offer defensive characteristics given growth concerns. We prefer USD government bonds due to their relatively higher yields and diversification benefits. We prefer inflation-linked bonds to conventional government bonds at this stage. Valuations look relatively more attractive given the sizeable moves we have seen this year, but remain vulnerable to further increases in interest rates.
Alternatives			Attractive diversification characteristics compared with equities and bonds. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated, visible revenue streams and commodities.
Cash			Cash has defensive qualities in potentially volatile markets.

Equities

Asset	Current positioning	Medium term view	Current view
Equities			Russia’s invasion of Ukraine, China’s response to Covid, inflation and rising interest rates have created a less favourable economic backdrop and resulted in higher volatility. Given the greater risk of “stagflation” (high inflation and low or negative growth) we prefer higher quality companies with the ability to pass on higher input costs to consumers. We maintain conviction in long-term, secular themes including healthcare and energy transition.
UK			Valuations remain relatively attractive. Larger companies have benefited from greater exposure to cyclical sectors. The Bank of England remains under pressure to continue normalising monetary policy given elevated inflationary pressures, despite growth concerns.
Europe			Given Europe’s greater economic exposure to Russia (particularly through energy) the inflation and growth outlook for the region looks more challenging. This could impact consumer and investor sentiment. Monetary policy is likely to remain relatively accommodative, while spending from the NextGeneration EU plan will also be supportive.
North America			The US economy has the potential to be more self sufficient in terms of both energy and agriculture and is therefore more insulated from events in Ukraine. Inflation remains a risk and consumer sentiment is the weakest it has been for over a decade. Valuations remain elevated despite recent moves and certain parts of the market are sensitive to rate rises, although the earnings outlook remains positive.
Japan			A delayed reopening, lower risk of inflation and more policy support (both fiscal and monetary) could lead to improved domestic growth, driven by consumption. Japan’s economic exposure to China could weigh on activity and sentiment in the near term, although valuations are supportive.
Asia/ Emerging markets			In the near term, China’s zero covid policy poses a notable economic headwind. However, lending activity is picking up again, with greater political support for fiscal spending to support growth. The earnings outlook remains robust and valuations are now at a significant discount to their 15- year average.

Bonds

Asset	Current positioning	Medium term view	Current views
Bonds			Longer-dated government bonds offer defensive characteristics given growth concerns. We prefer USD government bonds due to their relatively higher yields and diversification benefits. We prefer inflation-linked bonds to conventional government bonds at this stage. Valuations look relatively more attractive given the sizeable moves we have seen this year, but remain vulnerable to further increases in interest rates.
Government bonds			Long-dated government bonds provide some portfolio insurance characteristics, given increasing concerns over global economic growth. Valuations look relatively more attractive given the sizeable moves we have seen this year, but remain vulnerable to further increases in interest rates.
Investment grade			We prefer shorter duration and higher quality credit in the near term given the potential for further spread widening. Opportunities remain within asset-backed securities which offer a relatively attractive yield and often have floating rates, which are attractive in a rising rate environment.
High-yield			Default rates remain low although face headwinds from a rising cost of debt and a more challenging economic backdrop. Recent spread widening offers some valuation support.
Inflation-linked			We prefer US TIPS to conventional treasuries and UK linkers given the low cost of currency hedging. Inflation expectations have the potential to remain elevated in the short term although we are conscious of the potential impact of rising real yields from very low levels.
Emerging markets			Certain emerging markets could see near term balance sheet deterioration as a result of a more uncertain global economic backdrop and continued Covid headwinds. There is selective value across both US dollar and local currency debt.

Alternatives and cash

Asset	Current positioning	Medium term view	Current views
Alternatives			Attractive diversification characteristics compared with equities and bonds. We favour absolute return strategies with the ability to deliver less correlated returns as well as real assets with long-dated, visible revenue streams and commodities
Absolute Return			Selected opportunities in market-neutral strategies given increased stock dispersion and diversification characteristics.
Liquid private real assets			Long-dated revenue streams and income characteristics remain attractive in select parts of the market. Within this space we see good opportunities in digital infrastructure, specialist property and exposure to private companies.
Commodities			Gold is attractive as a diversifier and should provide portfolio insurance in the event of a meaningful equity market correction or economic growth shock. Broader commodities can hedge against further rises in inflation.
Equity-linked strategies			Offer attractive returns, especially in times of heightened volatility. However, there is a shorter-term correlation with equities.
Cash			Cash has defensive qualities in potentially volatile markets.

Key

	Positive
	Positive/neutral
	Neutral
	Negative/neutral
	Negative
	Up from last month
	Down from last month

Terms

Spread: the difference in yield between a non-government and government fixed income security.

Duration: approximate percentage change in the price of a bond for a 1% change in yield.