Investing amid geopolitical and interest rate risks

Originally published as a CIO Alert by Mark Haefele, Chief Investment Officer for Global Wealth Management

What’s happening?

Global markets fell last week as intensifying fears of a Russian invasion of Ukraine compounded pre-existing investor angst about higher US interest rates. After a 1.8% decline Thursday, the S&P 500 closed down a further 1.9% on Friday, with tech stocks underperforming, global energy prices moving sharply higher, and safe haven assets such as gold, the Swiss franc, and US Treasuries gaining ground on Friday.

US National security adviser Jake Sullivan said in a press conference on Friday the US believes Russian President Vladimir Putin could order an invasion of Ukraine at any time and encouraged Americans to leave Ukraine as soon as possible. The UK also urged its nationals to leave the country, citing the risk of a military incursion. The Ukrainian government has requested that Moscow provide detailed explanation of military activity in areas nearing Ukraine’s territory. Over the weekend,?diplomatic efforts continued with no tangible results—US President Joe Biden spoke with President Putin and stated that the US and its allies would be ready to “respond decisively” and “impose swift and severe costs” on Russia in the event of an invasion. He also noted that the US remains prepared to seek a diplomatic resolution but was equally prepared for other scenarios.

How do we interpret this?

The involved parties seem to be doubling down on their two-track approach of pressure and diplomacy.

According to Western intelligence, Russia continues to build up armed troops on its territory near the border with Ukraine and is holding joint military exercises with Belarus. President Vladimir Putin has also secured Beijing’s explicit support against further NATO enlargement.

Meanwhile, diplomatic efforts continue, with French President Emmanuel Macron’s visiting Moscow last week, and German chancellor Olaf Scholz planning to do so this week, though progress appears elusive so far.

In our central scenario, we still think diplomatic efforts will eventually lead to a dialing down of tensions. This may take several months, during which the possibility of flare-ups like the one we are experiencing today remains elevated. But we believe that both sides will ultimately calculate that military conflict comes at a too high an economic and political cost to be worthwhile:

For Russia, tighter sanctions by the West would seriously damage its long-term growth outlook and domestic sentiment could sour quickly, as protests in Belarus in 2020, in Russia in early 2021, and in Kazakhstan this year illustrate.

The European Union would also suffer sizable consequences, given that Russian energy accounts for nearly 40% of its gas imports and 30% of its oil imports. As for the US, the European security situation is drawing attention away from President Joe Biden’s plans to reinvigorate the American economy, against a backdrop of sliding approval ratings and already high energy prices.

That said, a military escalation and the imposition of fresh sanctions remain a risk: economic and political calculus hasn’t always prevented conflict in the past. We do think that it is unlikely that energy flows would be disrupted, even in the event of a military invasion: the Russian energy sector comprised close to 20% of Russian GDP and 40% of fiscal revenues in 2019, so a prolonged interruption of energy exports to Europe would significantly hurt the Russian economy. That said, a protracted interruption of Russian energy exports is of course possible, if less likely in our view.

For more of our analysis on the Russia-Ukraine situation, see our latest?Global Risk Radar?report titled “What do geopolitical tensions in Eastern Europe mean for global markets?” dated 25 January.

What should investors do?

Since the start of the year, market volatility has increased due to a combination of worries about the omicron variant, fears about rising US interest rates, and the risk of a disruption to Russian energy supplies. While market concerns about omicron have ebbed, volatility remains elevated as a result of repeated upward surprises in US inflation data and growing concerns in Eastern Europe.

Our base case is that inflation will fall and geopolitical tensions will ease over the coming months, allowing markets to move higher as investors refocus on a still-robust earnings backdrop. But investors should also consider how to manage potential downside risks emanating from our risk scenarios.

We believe investors can both position for our base case of strong global growth, while also preparing for potential risk scenarios with the following measures:

1. Diversify and keep a long-term view.?It is important to remember that drawdowns driven by geopolitical stress events are typically short-lived for well-diversified portfolios. As such, investors with diversified portfolios and a long-term investment plan should be well prepared for an eventual relaxation of geopolitical tensions as in our base case, as well as be better able to withstand setbacks from our risk-case scenarios.
2. Consider geopolitical hedges, including commodities.?We note that when geopolitical events are accompanied by a supply-driven oil price shock, markets have historically tended to see larger losses and taken longer to recover. This makes allocations to commodities and energy stocks an attractive option, in our view, to help investors hedge portfolio risks. Energy prices would likely rise in the event of a supply disruption, and regardless of the situation in Ukraine we expect oil prices to rise further this year thanks to rising demand and somewhat constrained supply. Alternative ‘geopolitical hedges’ include investments in cybersecurity, given that cyber warfare between state actors could play a role in any conflict, or establishing short positions in the Russian ruble. We would expect USDRUB to reach 80–90 in the event of an escalation, but we note the risk premium incorporated in the ruble has risen to a significant extent already so such a hedge could come at a high cost if tensions ease. Any further aggression in Europe could also favor a traditional safe haven like the Japanese yen over the euro.
3. Prepare for rising rates.?We think investors should mitigate the potential risks posed to portfolios by tighter US monetary policy by tilting toward parts of the market that can outperform in the face of higher interest rates. For example, the financial sector typically benefits as rates rise, thanks to higher net interest income. We would also expect value sectors to outperform growth sectors such as technology, which face the greatest headwinds from rising rates. In fixed income, we see US senior loans as offering some protection from rising rates due to their floating rate structure.?Click here ?for more. We also expect the US dollar to benefit from Fed tightening.
4. Buy the winners from global growth.?Despite recent volatility, it’s important to remember that we are still in an environment of robust economic and earnings growth, and in our base case we expect upside for equity markets over the balance of the year. While some of our tactical recommendations, like our preference for Eurozone stocks, may suffer in the event of a military escalation, sectors like energy and financials, value stocks, and commodities are both positioned to benefit from robust economic growth and are relatively well insulated from the primary market risks.

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