What If?

12 May 2022

Pascal Blackburne

Reflecting on how to position investment portfolios for a “World War III” scenario is, sadly, an irrelevant exercise. Practically every asset class would plunge, with only exposure to physical gold liable to curtail losses. We elect rather to consider what portfolio allocation would be most appropriate if, against all odds, a positive outcome to the war in Ukraine were to materialise. Easier said than done, though, to the extent that a resolution of current geopolitical issues would not remove other – more structural – market headwinds.

If the war in Ukraine were to end, the first and most obvious consequence would be a pullback in energy prices – warranting some profit-taking on related investments. That said, this pullback might prove only temporary, to the extent that the oil supply-demand equation is very much imbalanced. Put simply, unless economic growth collapses (which it should not in a positive Ukraine scenario), oil demand will continue to outstrip supply. Given the depleted inventory levels, this suggests continued upward pressure on the oil price over the medium-term, making exposure to this thematic still attractive for investors. If anything, the Russian invasion of Ukraine and ensuing energy sanctions have highlighted how dependent the global economy remains on fossil fuels, i.e. how challenging the transition to a greener world will be.

A short-term pullback in energy prices, as well as in grain prices (also a “casualty” of the war in Ukraine), would in turn mean that headline inflation indices move down from their current multi-decade highs. Again, however, there is a caveat. Energy and food prices are not included in core inflation indices. And the latter have also moved up significantly, indeed began to do so well before the war in Ukraine. Inflation matters a lot to the end consumer of course, but it is also a prime consideration for central bankers. The fact that core inflation now well exceeds the 2% target suggests that monetary policy in the US and Europe will remain on a tightening course. The Federal Reserve might even accelerate its rate hikes if the war in Ukraine ends, seeing its concomitant worries about economic growth dissipate. As for the old continent, although the ECB has not yet formally signalled an intention to raise its policy rate, the fact that Germany will be increasing bond issuance in the coming months even as the ECB reduces its asset purchase programmes is a recipe for higher bond rates along the yield curve.

In the fixed income space, we would thus not view an end of the war as the green light for a major strategy shift. Keeping duration short remains paramount in our opinion, and even inflation-linked bonds boast limited attractivity to the extent that break-even rates are already pricing in 6% inflation for the full year. There is little probability that realised inflation exceeds these high expectations in a positive geopolitical scenario.

Concerning equities, what could be expected in this “what if” constructive scenario? A short-term bounce, no doubt, in broad market indices – even though valuations have not receded that much during the past months (except for some high tech companies). From a regional allocation perspective, one might be tempted to see the US outperformance (particularly measured in EUR terms) reverse. It is true that the US is suffering less damage than Europe from the war in Ukraine, being geographically more distant and also self-sufficient in both agriculture and energy terms. Not to mention heightened revenues for large defence companies and oil & gas producers. That said, we consider it unlikely that the US’ advantages will go away completely if the war in Ukraine ends. Military spending is bound to continue increasing across the globe and Europe will likely still want to shift away from Russian gas, with the importing of LNG from the US seen as an interesting alternative (provided sufficient vessels can be found and new terminal constructions proceed as planned).

European companies on the other hand are also in a position to reap the benefits of the huge investments that will be needed to reconstruct the devasted Ukrainian cities and infrastructure. Not to mention Europe’s intention to become energy independent building windmill parks, solar panel installations and nuclear power plants. Taking this into account, there is still serious upward potential for European companies exposed to this value chain.

Chinese equities also have appeal in a positive scenario, being particularly cheap relative to other markets, but their upside might take some time to materialise mainly due to a lack of confidence from investors after the different interventions from the Chinese Government in stock market quoted companies (e.g. Alibaba). But right now, Covid-19 is the main preoccupation for the country’s authorities, with widespread lockdowns hurting both local demand and global supply chains.

The main question to answer remains, of course, the very likelihood of a positive outcome in Ukraine. Hopes initially grounded in peace negotiations between Russia and Ukraine have understandably been largely deflated and, with the US and the UK stepping up their financial support to the Ukrainian army, a protracted war is the most probable outcome – with an extension to other countries the downside risk. But, perhaps paradoxically, now that his target is getting access to better weapons and logistic support from military superpowers, President Putin may come to admit that victory is no longer possible and opt to pull out of Ukraine. The odds are low for such an optimistic outcome, but one never knows.

Maybe we should not completely forget certain safe havens such as gold for example?

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