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Ukraine war : which impacts ?


MARCH 2022


Laurent Denize

Laurent Denize,

We see no positive reason to change our positioning. It is too early to seize any opportunities, and we are holding onto our cash and are sticking to a defensive stance for the moment

We are living through some trying times. The scenes of war that we are witnessing at the gates of Europe are disturbing indeed, and we have never been closer to the brink of nuclear war. That being said, panicking is never a solution and, moreover, is often a poor advisor.

We’ll come right out and say it: if a nuclear-tipped missile is heading your way, the size and composition of your portfolio does not matter a bit... Hence, from a purely financial point of view, you should ignore existential risk, even if you are very concerned on a personal level. You must remove this ultimate risk from consideration but without passing over the many extreme risks that have already been commented on in full.

1. A look back at changes made in the portfolios

Since 14 February, before the war broke out, we had moved to a conservative posture and decided to underweight equities. We emphasise that our funds were not and are not directly exposed to Russian or Ukrainian assets (equities, bonds).

In our equity portfolios, we dialed back risk by raising our store of cash but without asking fund managers to alter their investment philosophy. We also sold the least liquid stocks in order to avoid any liquidity trap, particularly in small and micro caps, in the event that the situation takes a turn for the worse.

In our fixed income portfolios, we mainly worked on duration. We therefore stuck to our short positions but while adding investment grade issuers on short-dated paper in order to limit the impact of a possible decline in yields resulting from risk-aversion.

In our diversified portfolios, we took two sets of measures. First, we lowered our risk exposure by reducing our equity exposure or by selling high-beta corporate bonds (hybrid corporates, subordinated debt, CoCos, etc.). Then we tried to secure some means of diversification – gold in mandates allowing it, safe-haven currencies (JPY, CHF and USD) or hedging options, while reducing our overall exposure to Europe vs. the rest of the world.

While some investors felt that valuations were attractive enough to bet on a rally, we opted for caution and reduced our exposures rapidly. As a result, we managed to get through the recent period without any major collateral damage.

What about our strategies today? We can’t be satisfied with certain strategies that have underperformed, including fundamental equities and quantitative equities. Even so, our returns have improved recently, thanks to our conservative stance. On the bond side, performances have improved drastically, and our high yield funds are back in the top quartile in both one-year and year-to-date performance. Thematic funds have also held up well, which shows how robust our artificial intelligence-based investment process is.

2. Geographies and sectors best able to withstand this environment

Geographies: Since the war broke out, the relative performance of European assets has hinged on rising oil and natural gas prices, which are making stagflation more likely in Europe. Higher energy prices are, and will remain, a factor in the underperformance of European equities, a depreciation of the EUR vs. the USD, and a decline in German real yields vs. the US. Regardless of the scenario, it is hard to see how energy prices could decline significantly. The portfolios' equity exposure must be diversified even more than usual beyond the euro zone alone. That doesn’t necessarily mean that we are raising our US weighting, given how high valuations still are in the current environment. At 19 times 12-month forward earnings, US equities are indeed far from being discounted…

In emerging markets, we are raising our weighting of China. The 5.5% growth that it is targeting has served very clear notice of the authorities’ determination to achieve economic stability this year. To do so, they are putting in an aggressive fiscal stimulus amounting to about 3% of GDP. Meanwhile, they have set aside the annual energy-intensity reduction objective this year to give priority to energy security. Last but not least, we are seeing initial signs that China may give up its “zero-Covid” policy. Against this backdrop, we are overweighting Chinese domestic stocks (A-shares), which are better shielded from a possible regulatory crackdown and are better placed to benefit from infrastructure stimulus plans. We are also raising our weighting of the Chinese tech sector, which has underperformed its US peer by 45% over the past year.

Sectors: After a robust start to the year, banks took a direct hit from the Ukrainian crisis and gave up their entire 20% YTD outperformance. What is now the best course of action?

Well, let’s take a look back at what happened after the 1973 oil shock. Banks had plunged by 44% between 19 October 1973 and December 1974 and did not return to their pre-shock levels until 15 months later. Higher cost of capital could have a significant impact on income distribution (dividend yields are currently forecast at 7.5%) and limit banks’ potential. But a possible “Defense and Energy” stimulus plan, funded by a EU bond issue, should help limit the slowdown in Europe. With this in mind, the recent collapse in valuations to 49% of book value will soon clear the way for long-term strategic repositioning. That being said, the banks weighting must remain low and in accordance with sector volatility, or less than 5% of a portfolio.

We also prefer a return to healthcare, which offers good visibility on future cashflows, low debt, and reasonable valuations.

3. Major channels of our asset allocation

We see no positive reason to change our positioning. It is too early to seize any opportunities, and we are holding onto our cash and are sticking to a defensive stance for the moment. That being said, in our benchmarked portfolios we are narrowing our tracking-error vs. benchmarks for the purpose of taking some profits and managing risk. We continue to underweight equities, small caps in particular. As for high yield bonds, it is still too early to reinvest, even though spreads have widened strongly.

We don’t know how the situation will develop, but rest assured that our teams are fully committed to managing your investments. We must remain serene and flexible and adapt our strategies to changes in the environment. It is very likely that the worst has yet to come for the Ukrainians, but allow me a heartfelt wish that the worst is never certain to happen.

Yes, we are managing the short term, but let’s also try to gauge the long-term consequences of such a conflict. Greater energy independence, less globalisation, a new inflation regime and other developments would mean substantial changes in regions, sectors and individual companies, with both winners and losers. We are already working on this and will let you know what our findings are.

Allow me to close with a message of hope and peace.

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