For investors, these are challenging times. Amid the fog of war, uncertainty levels are high. In this CIO View, we explain — in the form of questions and answers — the latest thinking from our chief investment officer teams in Europe and Asia and provide tactical guidance on how best to hedge, protect and diversify portfolios.
How do you see the crisis unfolding?
On Feb 24, a full-scale invasion of Ukraine was launched by Russian forces. Media reports highlighted setbacks to Russian forces in the initial phase of the invasion, but subsequent reports suggest a substantially larger force is gaining momentum with the aim of overwhelming the Ukrainian resistance. In our view, there are two possible outcomes to the current open military conflict.
One is a rapid end to the conflict with a limited number of civil casualties. The other is a protracted war between Ukraine and Russia with a high number of casualties.
In the first case, the market would likely return to focusing on the overall (global) economic drivers rather swiftly. Risk assets would sharply rebound and the economic outlook would be largely unchanged. Russian assets would likely stay depressed for longer.
In the second scenario, we may be looking at a darker picture of an energy crisis in Europe, heightened risk of policy errors and, as a result, an increased probability of a recession. In that event, a more challenging and difficult market environment would ensue. On balance, the weight of probability suggests the first scenario is more likely.
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Hence, we keep portfolios positioned for above-trend growth with elevated inflation and central bank tightening — we thus remain neutral equities and underweight government bonds. We acknowledge that the current market weakness and risk-off environment may extend further. However, markets can violently swing back and we would take neither an overweight nor an underweight exposure during these volatile times. More importantly, we advocate adding risk-mitigating assets to prepare for the more negative scenario.
Which hedges do you favour?
Energy stocks: Energy stocks benefit in both scenarios described above. In the event of a rapid end to the conflict, energy stocks would perform well amid an unchanged scenario of strong global growth. In the alternate scenario of a protracted war, oil prices would likely remain significantly higher and energy companies would benefit from supply shortages.
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Financial stocks: Global diversified financials will likely outperform the MSCI World given their inexpensive and undemanding valuations, attractive dividends, ongoing buyback announcements and the rising rates environment, which remains supportive of net interest margins and improved earnings.
Defence and cybersecurity stocks: The current events mark nothing less than a shift to a new multi polar world order in which China and Russia play critical roles. This is likely to trigger a multi-year wave of defence spending and cybersecurity upgrades by the private and public sectors.
Defensive dividend stocks: In their quest for defensive ways to invest in equities, investors may find some shelter against volatility in the defensive nature of dividend stocks, into which they should diversify their core equity holdings.
Chinese government bonds: Chinese government bonds — both Chinese yuan and US dollar denominated — are among the very few assets to act as a true diversifier. They are not exposed to the inflation and monetary tightening headwinds other developed-market and emerging-market government bonds face, as China is currently in the midst of a low inflation and monetary easing cycle.
Diversified commodities index: Russia is an exporter not only of energy commodities (oil, gas and coal) but also of metals (aluminium, nickel, platinum group metals) and soft commodities (grains, cereals and fertilisers). As sanctions are extended — and if these were to target actual physical flows — we expect supply constraints to lead to high commodity prices overall.
Commodity and oil-related currencies: Higher energy and metals prices are likely to give some support to the Australian dollar, Canadian dollar and Norwegian krone. Among these, we think the Canadian dollar offers the best mix of commodity price support and progression toward monetary policy tightening.
What does the conflict in Ukraine imply for the pace and quantum of Fed and ECB monetary policy?
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The US Federal Reserve (Fed) and the European Central Bank (ECB) are likely to continue guiding toward rate hikes. The current situation is dramatically different from the past two decades because the developed economies go into this commodity price shock with already high inflation, particularly in the USA.
The shock to markets caused by the Ukraine situation suggests that the Fed may be more likely to start its rate hiking cycle with only a 25 basis points (bp) increase in the Fed funds rate in March instead of a 50 bp hike.
But we maintain our forecast of a cumulative 175 bp in interest rate hikes by the Fed during 2022. In light of our rates view, we expect US Treasury yields to rise in the months and quarters ahead, to 2.2% in three months and 2.6% in 12 months.
Is the current crisis bullish or bearish for the US dollar?
This is a complex question because the implications of Russia’s actions are different for the US dollar, low yielding non-commodity currencies and commodity currencies.
Over the next few weeks, the Euro is likely to remain under downward pressure against the US dollar. More broadly, a doveish shift by the ECB could further weigh on the single currency, but if the ECB sticks to its recently adopted more hawkish inclination, the Euro might find some support as long as the outlook for the global economic cycle remains solid.
The Euro could therefore remain a bit on the backfoot in the very near term, but further out we expect a rangebound Euro and US dollar and perhaps even a mildly positive uptrend as the global economy recovers and the ECB starts tightening, limiting the rate gap.
Although the Japanese yen and the Swiss franc have rallied somewhat in response to the military action, the US dollar will probably rebound against them as the Fed makes clear that it will proceed with monetary tightening. However, higher energy and metals prices are likely to give some support to the Australian dollar, Canadian dollar and Norwegian krone. We think the Canadian dollar offers the best mix of commodity price support and progression toward monetary policy tightening.
What is our outlook for the Eurozone and European senior loans?
In Europe, the negative income shock for households along with higher costs for companies are expected to shave 0.5% off our prior Eurozone growth forecast. Specifically, our economists now expect Eurozone 2022 GDP growth of 3.3% (down from a prior forecast of 3.8%), while their growth expectations for the US, for example, remain unchanged for now.
Floating income opportunities — specifically, senior secured loans — offer attractive absolute value in Europe and the US and better relative value compared to high yield bonds, in our view. The asset class continues to be supported by a benign default landscape in the near term.
Unsurprisingly, given the recent volatility in equity markets, the loan default rate — a market measure of stress — has increased slightly (from 0.99% at the end of December) but remains far below the three-year average of 4.20%. The favourable difference between implied and realised credit losses benefits collateralised loan obligation (CLO) investors, who are rewarded with a leveraged return between the post-default yield on CLO assets and term-finance costs.
Is gold a good hedge in the current environment?
Given still rising inflation and high geopolitical risks, gold may remain supported for now, but we note that if real yields ultimately rise, this would be negative for precious metals. At the moment, given that uncertainty is set to persist, gold is likely to remain well supported in absolute terms. Should geopolitical tensions ease at some point, gold would likely pull back.
Nevertheless, the longer the current conflict lasts and the more it spills over into broader confidence and activity, the more likely central banks are to delay their tightening plans.
How do you see Asia amid the current tensions?
Inevitably, the direct effect of the Russian invasion on emerging Asia will likely be transmitted mainly via the impact of higher commodity prices. Oil and gas dominate, with Indonesia and Malaysia the region’s beneficiaries. India, Thailand and Korea stand out as the economies most exposed to higher energy prices. Indonesia will likely benefit if the conflict curtails Russia’s exports of aluminium, copper, gold and nickel.
China is likely to be resilient, particularly Chinese sovereign bonds, given a low correlation with global assets and an accommodative People’s Bank of China. China’s relatively insulated economy, supported by a robust current account surplus and the flexibility and independence to ease monetary policy, should largely escape the damage of first-order effects. However, we remain neutral on Chinese equities given regulatory risks and the fact that they are not immune to a correction in global equities.
In currencies, we view the Singapore dollar as defensive because of the likelihood that its central bank will tighten policy in April by increasing the scope for appreciation of the Singapore dollar against its basket. In contrast, the Thai baht is one of the regional currencies most negatively exposed to higher imported energy prices and likely to weaken against the Singapore dollar.
Would you suggest any Asiaspecific hedges?
From an Asian market perspective, index option pricing, which can be used to hedge further downside risk, remains inexpensive compared to historical levels. The cost of hedging in currency and equity markets, measured by so-called “implied volatility,” is substantially below levels that were seen in 2020.
Thus, investors who wish to stay strategically invested to participate in the medium-term economic recovery in equities should consider overlaying their investment portfolios with these hedging solutions.
One possible hedge is via a regional equity market, specifically the Hang Seng Index (HSI). The implied volatility (the main indicator of hedging costs) in the HSI is currently at 26%, less than half of its peak during the March 2020 market selloff and slightly above the five-year historical average. In light of the situation, buying a put option on the HSI could protect against potential near-term downside in China’s equity market.
In the foreign exchange market, the Japanese yen is likely to rally in response to escalations of the conflict. But these rallies are likely to prove temporary as the impact of future shocks dissipates and should our assumption be correct that the US Fed will proceed with its plans to tighten policy and hike rates by 175 bp this year.
John Woods is the Asia Pacific chief investment officer at Credit Suisse
