Hold tight in spite of market volatility: Russia, Ukraine, and Inflation
Although many of you are well used to my comments to ignore short term issues with markets and to remember that you are investing for the long term, I thought this ad hoc communication might help to explain what’s currently happening and so hopefully allay some of your concerns.
Trying to time markets is inherently challenging, and over time has been proven to erode long-term value. It’s natural to feel uncomfortable when markets are experiencing short-term volatility – however, it’s important not to lose sight of long-term financial goals.
I, like many of you I’m sure, have watched events unfolding in Ukraine over the last few days. This is a clear attack on democracy in the region and we are already seeing that the humanitarian impact is likely to be huge. Amidst this, no doubt, many of you will have been concerned about the impact this might have on your investment portfolios.
What’s important to understand is that recent volatility is not only caused by events in Ukraine. We were already seeing the markets being impacted amid concerns regarding rising inflation.
Ukraine and Russia
Tensions between Ukraine and Russia have been a recurring feature since Ukraine’s independence in 1991.
Russia has been moving troops into neighbouring areas for several months, citing training exercises, which are common. However, intelligence warned of an impending invasion by Russia in Ukraine. On February 22nd, Putin ordered Russian troops into two rebel-held regions in eastern Ukraine, and then on February 24th Russian troops entered Ukraine from the North, South and East, targeting military infrastructure and border units in major cities, including the capital, Kyiv. Putin described the attacks as a “special military operation” to defend people in breakaway areas.
Western nations have since unveiled further sanctions against Russia.
2022 was already off to a bumpy start with surging inflation causing fears of overly aggressive monetary policy. The possibility of a Russian invasion in Ukraine had further increased market uncertainty which had already led to falls in global equity markets and increases in the price of safe-haven assets such as US Treasuries and gold over February. News of Russian troops entering Ukraine in the early hours exacerbated these moves.
As you might expect, Russian assets have felt the most pain, with expectations of further sanctions from Western countries. The Russian Equity market was already down from its peak in October, before falling further after troops entered Ukraine. Russian bond yields have also increased from approximately 7% in Summer 2021 to around 13% now and the Russian rouble is also at its lowest level against the US dollar since 2016. Additionally, given the importance of Russian supplies for oil and natural gas, the prices of both these commodities have risen, with the price of oil rising above $100 for the first time since 2015 and gas pricing rising.
Although your portfolios will have exposure to Global Equities, there will be very limited exposure to Russia and Ukraine, so will be largely sheltered from any direct impact.
How the situation evolves is uncertain and unpredictable. However, as always, the best defence against uncertainty is diversification across asset classes, regions, currencies, and styles.
The situation could certainly get worse from here. Russia could launch a full-scale invasion across the whole of Ukraine with the intent to occupy all regions, which could lead to military involvement from Western powers. This would likely lead to a further drop in equity markets (and a rise in safe-haven assets). However, a lot of uncertainty has now been priced into markets, and any stabilising of the situation would likely settle equity markets.
Commodity price rises have benefited energy companies, and rising interest rates have been positive for financials. This has given a boost to more ‘value’ positions in portfolios which have held up well so far this year.
“Highest inflation level in 30 years” headlines have made inflation the hottest topic in markets (prior to the Russian invasion of Ukraine). However, surveys expect inflation to be transitory and that Central Banks remain in control to bring inflation back down to target within a few years.
As a quick overview, the cause of recent inflation ultimately boils down to a shortage of supply relative to the high level of demand. COVID caused both production and consumption of goods and services to be restricted. Land sat fallow, labour was not able to work or, where it could, worked less effectively (at least in the short-term). Capital (e.g. tools and equipment) was underutilised, but at the same time, consumers tightened their belts in the face of a recession.
Demand then returned and exceeded normal levels (fuelled by low interest rates and generous fiscal policies in the form of unemployment/furlough support and tax relief). Supply remained constrained, however, in the form of fewer resources (raw materials, inventory levels, shipping availability), causing supply chain disruptions and ultimately feeding through to prices and thus inflation. The latest developments in the situation in Ukraine have caused oil prices to rise sharply, fuelling inflation further.
Broadly, medium-term (2-3 years) and longer-term (5+ years) inflation expectations remain anchored relative to historic averages, although have been rising of late (particularly in financial markets and company surveys). This does still indicate that markets, households and companies are confident in Central Banks’ abilities to keep inflation under control – through rate changes or letting temporary effects wash through. The evolving situation in Ukraine may have some impact on that in future survey results.
Looking at interest rate expectations, there is a clear indication that markets expect the Federal Reserve, the Bank of England, and even the European Central Bank to raise rates in the near future and much faster than was thought only a few months ago.
However, rate rises are not the only force expected to tame inflation. Each quarter, the Bank of England projects CPI 3 years into the future, with two options: unchanged interest rates and market expectation interest rates. The latest report shows that expected interest rate rises (around 0.75-1%) are only expected to reduce inflation by 0.5% over 3 years. Most of the inflation reduction comes from temporary effects dissipating as the one-year comparator rolls off. Oil price pressure may, of course, have the opposing effect on inflation and a close eye needs to be kept on how the situation in Ukraine develops from here.
So, there is consensus amongst markets, businesses and households expect that Central Banks will ensure inflation falls back down towards target over the next 2-3 years. This will be delivered by modest rate rises, as well as an easing of some temporary factors like supply bottlenecks and no further escalation of geopolitical activity, which would tame energy prices.
As supply chains normalise, monetary and fiscal stimuli are withdrawn, geopolitical tensions, hopefully, settle and people go back to spending less on goods and more on services, inflation is very likely to decrease.
It may not be as quick as we hope, but inflation should come down and when it does start doing so, a lot of investor inflation worries will decrease. Investors should take steps in the meantime (see above) but a big part of the cure for inflation will be simply enduring until it passes.
Don’t compare your portfolio to the FTSE
It is understandable that many people tend to use the FTSE100 as a reference point, given they’re likely to hear it mentioned on the news. However, it is generally not relevant to their financial plan.
When building portfolios, our primary goal is to maximise expected returns for a given level of risk whilst ensuring diversification. As a result, your portfolio is always exposed to a wide range of asset classes, styles, regions, and currencies. Hence comparing to a single, regional benchmark is never a good idea.
The takeaway here is, as ever, to ignore short-term market corrections. It is, of course, natural to feel worried in times such as these – political conflict on this scale certainly makes for a feeling of unease. But where your portfolio is concerned, please rest assured that it’s all in hand. Remember that you’re in it for the long haul.
This communication is for general information only and is not intended to be individual advice. It represents our understanding of the law and HM Revenue & Customs practise as of 28th February 2022. You are recommended to seek competent professional advice before taking any action.