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What does the crisis in Ukraine mean for asset allocation?
Every month, our Asset Allocation Committee meets to discuss and debate our market outlook.
How has our asset allocation changed month-on-month?
Here Bernard Swords, Chief Investment Officer, presents our views.
Financial markets were already under pressure this year – and the conflict in Ukraine has added to that. There is now much concern about the movements in energy prices and whether they could derail the global economy.
There are also fears that the conflict could broaden out or be long drawn out. But movements in the diplomatic channels over recent days offer some hope that neither of these outcomes will occur. Nevertheless, we are living with the risk of them.
The main cause for optimism is that it is in nobody’s interest for either of these outcomes to occur. But this remains the greatest risk to the global economy – and the most difficult to predict.
Market moves since the invasion
Equity markets are bearing the brunt of the volatility. Since the beginning of the conflict, world equities have corrected by almost 5% in local terms although Euro weakness has more than halved that loss to 2.3%.
At a regional level, Europe has significantly underperformed. The region is most exposed to the impact of sanctions on energy products not only as it is a large energy importer but also due to the source of those energy imports and how able it would be to change sources given the logistic stresses that existed before the conflict.
As you’d expect, in equity markets there are distinct differences between the sectors. Energy has been the leading way alongside defensive sectors – i.e., Utilities and Healthcare. Meanwhile, Consumer Discretionary (energy tax on consumers) and Financials (credit concerns) are among the biggest laggards.
Fixed income markets did not provide any relief. Both the European Central Bank and the Federal Reserve indicated that they would continue on the course of reducing bond purchases. In the US, we expect to see interest rate increases start this month and, in the euro area, there is a possibility of an increase in interest rates this year.
Economic growth under threat, but by how much?
Before the war began, the outlook for economic growth across the globe and in each of the major regions was strong.
The spike in energy prices has resulted in downgrades to the economic outlook. However, the scale of the downgrades thus far has been manageable. Global growth for 2022 has been cut by anything between 0.7% and 1.0% – that still leaves us above trend growth at between 3.5% and 4.0%.
Of course, these forecasts can change again but they have been based on Brent oil prices averaging over $100 for the rest of this year, so they are at least realistic.
Up to the time of the invasion earnings forecasts were still being upgraded. 2023 earnings were increased by 1% over the last month, bringing the prospective multiple below the average of the last 15 years.
Higher input costs could put pressure on margins. However, corporates have been dealing with rising input costs for some time and delivering stronger-than-expected earnings growth. The greater challenge would be dealing with lower sales growth but if that can be maintained above trend, then it should be manageable.
Policy response more constrained, fiscal to the fore
Central banks are in a somewhat of a bind: there is doubt over the growth outlook, while at the same time, inflationary pressures have also increased. So far, they have indicated no change to their plans to tighten monetary conditions – and we would not expect much change.
Fiscal policy could help. One of the outcomes from the pandemic has been that governments are more inclined to deficit spend to offset dislocations in economies. And so, we expect to see government response in the euro area to alleviate some of the impact of higher energy prices.
Asset allocation: what’s changed?
We were overweight equities before Russia’s invasion of Ukraine and we have not changed this. This may seem strange but it is based on the global economy still being in a robust condition. This is evident from:
- The recovery from the Omicron-induced slowdown;
- Low and falling unemployment rates;
- Excess savings;
- Corporates needing to rebuild inventory levels; and
- Profit growth that has been consistently stronger than expected.
Forecast growth rates have been reduced but they still stand above trend levels for both 2022 and 2023. It does not look like we are coming close to the end of the cycle – and if that is the case, one should maintain an overweight position in equities.
Returns from other asset classes do not look enticing: cash is still yielding a negative return and bond markets still have to contend with reduced central bank buying and rising interest rates. This keeps us underweight fixed income markets.
Our sector allocation suffered over the last month due to low exposure to the Commodity sectors (Energy and Materials). We have seen extraordinary moves in Commodity prices which we do not believe are sustainable through the rest of this year and thus are not changing our exposure here.
We were moving to a more defensive bias but put that on hold last month as the price falls in some of the cyclical sectors were too extreme to make any more adjustments.
We made no changes to our fixed income strategy. The low duration worked well for us as yield levels rose.
Growth concerns have caused corporate spreads to widen which is hurting us but the higher running yield that we are getting is offsetting some of this. When confidence about the growth background returns, these spreads should narrow in again.
Bernard Swords,
Chief Investment Officer
Bernard joined Goodbody in 2002 and is Chief Investment Officer. As CIO, he formulates and implements the global investment strategy and chairs the asset allocation committee. Bernard also leads the investment research team.
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