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Conflict in Ukraine undermines growth outlook
March 2022
Continued concerns on rate hikes and a commencement of hostilities in Ukraine further extended losses in markets during February. We maintain our mild overweight to risk assets on a medium-term outlook.
Our view
For the first time in many months neither coronavirus nor inflation are front of mind for investors. Rather, the Russian invasion of Ukraine, arguably the most significant European incursion since the Second World War, has rattled already volatile financial markets. The onset of conflict initially saw equity markets sell-off sharply before a later correction. This volatility is expected to continue in the near-term and investors should pause to remember the merits of a long-term investment strategy during these periods of uncertainty.
At this juncture it’s still too early to frame the medium-to-longer term consequences of the war on the global economy and markets, although Europe appears most vulnerable to a protracted battle, with the region accounting for 7 of Russia’s top 10 trading partners in Q3 2021. Western nations have already imposed significant sanctions on Russia and, as a major supplier of commodities including natural gas, oil, wheat and aluminum, the flow-on effects from any supply-side constraints particularly amongst an already fragile energy market could further ignite inflationary pressures across the continent and globe.
US President Biden has already sought to calm markets, providing reassurances in the form of the release of US oil reserves and ensuring initial sanctions aren’t directly targeted towards the energy sector. After initially spiking to more than USD 100 a barrel following the start of the incursion, brent crude quickly settled back below triple figures, however, it has since risen sharply again and is expected to remain volatile for some time. The aim of any sanctions is to provide longer-term headaches for Russia while seeking to minimise pain for Western consumers.
Inflation and rate hikes may not be the leading headline, however, stronger energy and commodity prices are likely to keep inflation elevated, crimp growth prospects and consumer sentiment and force central banks to carefully reassess the path towards policy normalisation. While it may be tempting to further stimulate economies if growth begins to wane — or at least ease the velocity of hikes — the downside risk is higher and more sustained inflation the likely outcome. Furthermore, policy is already extremely accommodative, so the level of dry powder at the disposal of central banks is limited.
On the surface this paints a rather grim outlook in the very near-term, particularly for Europe, however, we remain broadly constructive towards equities. If history is a guide, the last two similar actions by Russia in Georgia and Crimea also created some uncertainty and volatility, but the market reaction was temporary.
On a more positive note, corporate earnings remain sound among developed markets; unemployment very low and pent-up demand and strong household balance sheets should continue to be supportive of growth assets. If growth does begin to falter and a more dovish narrative is struck by central banks, this could provide further impetus for equities.
Russia - Top 10 Trading Partners Q3 2021*
*Total Trade ($M)
Source: Bloomberg, ANZ PB&A CIO as at 25 February 2022
What this means for our diversified portfolios
We remain very mildly overweight growth assets with the recent weakness in equities taking us closer towards benchmark. In the absence of any extreme off-benchmark positions across portfolios we are adopting a ‘wait and see’ approach and view any immediate reactive changes to potentially short-term market movements as imprudent when considering a long-term investment strategy.
While open to the possibility of tactically changing portfolio positions in the period ahead, we don’t see the need to act impulsively without gathering further information, a better understanding of the longer term impact of Russia’s policy, and the reaction of both governments and central banks.
Earlier this month we adjusted portfolios to align with our new Strategic Asset Allocation (SAA), whilst retaining our mild overweight growth position.
ANZ investment strategy positions - March 2022
The Australian share market performed relatively strongly over the earlier part of February as a mixed reporting season saw the share price of many major companies, including the banks, BHP, CSL and Woodside react positively to reporting releases and forward guidance. Alongside the continued outperformance of value versus growth stocks in February, the ASX 20 (2.9%) again outperformed the ASX 300 ex-20 (1.4%) over the month. In fact, despite volatility throughout, the local bourse made promising month-to-date gains prior to the Russian invasion and actually finished the month in positive territory rising more than 2% over the month.
We are mildly underweight Australian shares this month following our SAA changes which see a higher strategic allocation to global shares and the introduction of high yield debt. The possibility of prolonged conflict in Ukraine and heavy sanctions imposed on Russia could potentially be a relative boon for the domestic market with commodity prices likely to remain supported due to supply-side constraints. Alongside the reopening of international borders to tourists this could provide some positive near-term tailwinds for the education, tourism and leisure sectors. However, we currently remain more positive towards global developed markets due to stronger earnings momentum and better diversification traits.
ASX 20 vs. ASX 300 ex-20 - 1 month performance
Source: Bloomberg, ANZ PB&A CIO as at 28 February 2022
The volatile backdrop for global share markets persisted in February, with developed markets again under pressure following the January sell-off. Value stocks were once again the better performer as the market continued to price a steeper tightening cycle for the US Federal Reserve (Fed) and growth stocks were particularly punished for any misses during earnings season. The month was capped off by heightened geopolitical tensions and ultimately Russia’s invasion of Ukraine which initially sent share markets tumbling before a sharp recovery.
In March, we retain our mild preference for developed market equities across portfolios. Consumer demand is still strong in the US, unemployment remains low across much of the developed world and we believe that recent geopolitical tensions and the market pricing for the path of central bank hikes may be overdone. If this is the case it could potentially provide a dovish surprise for developed equity markets.
European equities appear most vulnerable at present given the potential for ongoing geopolitical tensions in the region. Both Russia and Ukraine are major suppliers of commodities to Europe and any energy or agricultural shortages could be detrimental to its recovery. In recent times, incursions of this nature have had a relatively temporary impact on markets and therefore we believe it is too early to change our positioning to (and within) developed market equities. We continue to hold a balanced approach to our portfolios with quality/growth represented by the US, and cyclical/value exposure via Europe and Japan.
While risks appear skewed to the downside in the very near-term and inflation fears continue to fester, monetary policy is accommodative, and TINA (‘there is no alternative’) remains a compelling proposition given low expectations for bond returns. Our upcoming SAA changes will see a slight increase to developed market equities and if there are any sizeable dips in the market once geopolitical risks have stabilised, this could present the opportunity to increase our positioning further.
Developed Markets - February Regional Performance
Source: Bloomberg, ANZ PB&A CIO as at 28 February 2022
In March we hold our benchmark position to emerging market shares, however, we will be introducing a new allocation to our balanced portfolios and increasing the weighting in our moderately aggressive portfolios in line with our SAA changes. Emerging markets performance has stabilised on a year-to-date basis following the underperformance of 2021. Relative valuations remain attractive compared with developed markets, but geopolitical risks are clearly heightened across emerging markets and therefore it is still too early to upgrade our stance on a tactical basis within portfolios.
Despite the possibility of policy easing in China, China’s zero-Covid policy remains a headwind and we need to see a stronger pick-up in growth before increasing our exposure to emerging markets. Amongst poorer nations, COVID-19 continues to be an issue as vaccination rates lag developed markets — further stalling growth prospects.
On a medium-term basis we remain positive towards the asset class and continue to look for signals to upgrade our stance and tactical positioning to emerging market shares.
Emerging Markets – February Regional Performance
Source: Bloomberg, ANZ PB&A CIO as at 28 February 2022
This month we remain at benchmark to listed real assets. This position is built on a mild underweight to listed infrastructure and a benchmark position to Global Real Estate Investment Trusts (GREITs). Within our moderately conservative portfolios, we have reduced the overall allocation to listed real assets in line with our SAA changes.
GREITs have performed broadly in line with global equity markets this year as discussion surrounding the hiking cycle has led to a more volatile path for most risk assets. At this stage we see no reason to upgrade our stance with valuations no longer attractive on a relative basis. The asset class remains an important component of multi-asset investing and provides good diversification, attractive yields and in the current environment, a sound hedge against inflation.
We retain a mild underweight to listed infrastructure which has started to outperform global equities in recent times despite the upwards move in rates. The long-duration nature of these assets, the higher outlook for rates and resulting potential of a rise in valuations means we retain a cautious stance this month. The asset class provides higher-beta traits to capture upside swings and defensive characteristics to provide protection against drawdowns and therefore we maintain conviction in its role within multi-asset portfolios.
Global REITS vs. Global Equities
Source: Bloomberg Finance L.P., DWS Investment GmbH; as of February 2022
We have initiated our exposure to global high yield as part of the SAA update at a neutral weighting.
We see the potential benefits of global high yield exposure as part of a diversified portfolio coming primarily in the form of income generation at a time when yields are historically low, upside return long-term return potential and diversification from other growth assets.
That said, we currently do not have enough conviction on the asset class to justify a meaningful deviation from benchmark. We believe U.S. high yield should be well supported by sound fundamentals in the form of low default rates and attractive carry so are comfortable with having exposure. However, in the current climate our preference to express our mild overweight to growth assets is via developed market equities.
U.S. vs. EUR Investment Grade Credit Spreads (bps)
In February, the 10-year Australian government bond yield settled above two per cent after remaining at the upper end of its trading band for most of the month, rising close to 25bps over the month as the domestic bond market continued to sell-off strongly following continued inflationary pressures, offshore central bank rhetoric and geopolitical tensions.
The RBA remains more dovishness than global counterparts with the February release of the Q4 Wages Price Index providing some support for its “patient” approach to normalising policy. Regardless, we believe the RBA is likely to commence hiking in the second half of 2022 as data continues to build momentum, providing enough evidence to meet the conditions set by the RBA to raise policy rates.
This month we have marginally upgraded our preference for duration in portfolios, however, we retain a mild dislike overall. The upcoming changes to the SAA have seen a 50/50 benchmark allocation to domestic and international fixed income introduced - as opposed to the previous 60/40 bias towards Australian bonds. As a result, our previous mild underweight to Australian bonds is now sitting at a mild overweight - a position we are currently comfortable retaining.
10Y Australia Bond Yield
Source: Bloomberg, ANZ PB&A CIO as at 1 March 2022
The 10yr US Treasury yield continued its upward momentum in February, closing within striking distance of two per cent by month end, despite investors seeking safe-haven assets as the Russian incursion began. The initial drop in yields following the invasion reversed course, reflecting a similar turnaround seen in equity markets.
The prospect of a prolonged conflict in Ukraine and the ensuing sanctions imposed on Russia bring with them the prospect of higher energy and commodity prices. This has the potential to sustain inflation at already elevated levels, dent consumer confidence and impinge on the growth outlook. An already tricky tightening cycle has just become more difficult for central banks to navigate. While tempting to ease monetary tightening if growth begins to falter, the downside risk is stickier inflation coupled with a growth outlook that may already be beyond resuscitation. We believe the hiking cycle will continue; however, it is likely to be less aggressive than currently priced in.
Owing to the change in our strategic weighting to global bonds this month (a higher strategic allocation to global fixed income), we are now positioned with a mild underweight to international fixed income (as opposed to benchmark last month). Overall, this results in an underweight to duration within the portfolio’s fixed income exposure given the higher duration of the global fixed income allocation when compared to Australian fixed income.
10Y Australia vs. U.S. Treasury 10Y
Source: Bloomberg, ANZ PB&A CIO as at February 2022
The AUD has resisted recent overtures to crumble alongside risk assets, grinding higher in recent weeks. While geopolitical risks have weighed on the AUD’s resilience it has maintained its steady climb to sit above its January lows. Strong commodity prices and Australia’s distance from Europe appears to be providing some support. In the near-term, monetary tightening offshore and a further downturn in risk appetite could prove problematic.
As part of our transition to the new SAA, we are taking the opportunity to change the mix within our global equity exposures and slightly increase our underweight to the AUD. This is reflective of recent relative strength and we continue to prefer developed market foreign currency exposure (in particular the USD) which is intended to provide some relative protection in the event of any further equity market weakness.
AUD Has So Far Withstood Souring Risk Appetite
Source: Bloomberg, Macrobond, ANZ Research as at February 2022
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