WAR IN UKRAINE:

SHOULD WE ADAPT OUR INVESTMENT STRATEGY?

Since Russia invaded Ukraine on 24 February, global equities – as measured by the MSCI World Equity Index – have fallen by 4%. However, this decline follows an already meaningful correction of 10.4% since the start of the year.

The question for us as active investment managers is: do we wait for more clarity regarding the potential outcome of the conflict – and its knock-on effects on economic growth, commodity prices, inflation rates and economic policy response – before we act on substantial absolute and relative price movements of financial assets? If we do wait, do we risk losing out on the benefits of a possible equity market rally should the war be short-lived and some sort of settlement is reached?

At Sanlam Private Wealth, we take decisions based on our tried-and-tested investment philosophy and rules that hold sway no matter the circumstances or the magnitude of the uncertainty we are faced with. In this regard, the Russia-Ukraine war is one of the factors we consider as part of the broader investment landscape we find ourselves in.

RISKS ‘BAKED IN’?

The key issue is whether the war has in fact fundamentally changed the investment landscape, or whether the risks associated with this conflict have already been baked into global equity prices. The latter consideration is crucial – we have witnessed so many times in the past that once certainty or normality returns to the market, it is too late to reap the benefit of investing in cheap assets.

Before Russian President Vladimir Putin even started his sabre-rattling along the Ukrainian border, our macro investment outlook was clear: investors had become far too complacent in terms of their views on inflation. We held that global interest rates were likely to surprise on the upside, which is normally not good for the prospective returns of equities as an asset class, and it would also weigh on the growth rate of global economic activity. In other words, our view was that the global economic growth rate was likely to slow more than expectations... and then the threat of war became reality.

Although the Russian and Ukrainian economies are surprisingly small – Russia’s gross domestic product (GDP) as a percentage of global GDP is around 1.7% – both countries produce and export commodities that are important to the rest of the world. These range from energy (oil and gas) and platinum group metals to wheat and maize. If supply is disrupted it would be logical to expect that the prices of these commodities will spike and create further pressure on already problematic consumer prices. The war has undoubtedly increased the risk of higher inflation for 2022.

HEADWINDS FOR GROWTH

Potentially higher interest rates and the demand destruction of higher consumer prices will create additional headwinds for global economic growth, not to mention the direct impact the disruption of global trade will have. Of course, the longer the war continues, the more profound will be the negative impact on these all-important macro-economic variables. But unlike in 2020, global economic authorities would have less scope to stimulate economic activity, given the already low interest rates and potentially higher inflation.

During 2021 we held the view that global equity prices were elevated and not priced for the possibility of future higher interest rates and potentially disappointing economic growth (we didn’t forecast recession for 2022). We’ve therefore trimmed – arguably rather early – the global equity exposure in our multi-asset portfolios by 4%. We’ve acted on the basis of valuation, expected higher interest rates and the expectation that the economic growth rate would slow.

Although global equities have, on average, declined by only 4% since the start of the war, we’ve witnessed profound sell-offs in certain markets. The Nasdaq Composite Index is now trading below its opening value of January 2021, and is down by around 20% from its peak recorded in November last year. Similarly, international banks have sold off aggressively even though there is very little evidence that the international banking system is under threat – as was the case during the Great Financial Crisis in 2008/9.

OPPORTUNITIES CREATED

Against this background, we believe we can selectively start to acquire equities in areas where negative investment sentiment related to the conflict has already created opportunities for long-term investors.

Commodity prices have spiked spectacularly over a very broad spectrum, with energy-related commodities leading the way. Mining shares have followed the trend higher, and our clients have reaped the benefits in their local equity portfolios. We will monitor this sector carefully, and won’t hesitate to trim in areas where the share prices have moved beyond our valuation based on normal commodity prices.

Our team at Sanlam Private Wealth has examined equity market responses during various regional conflicts since the Second World War. The average S&P 500 drawdown – the decline from the peak to the lowest point after the start of the conflict – was 9%. Only on two occasions (the Gulf War of 1990 and the war in Afghanistan in 2001) did we witness drawdowns of 20%.

Should the overall view be that the Russia-Ukraine war is likely to be drawn out, with long-lasting economic side effects, one might consider remaining on the sidelines for longer. However, regardless of the geopolitical situation, the deeper the sell-off, the better the investment opportunities for long-term investors.

Our approach at Sanlam Private Wealth is to use these opportunities to buy equities as prices come under pressure – in a discerning way. Clients with portfolios with high cash balances may have witnessed some action where we’ve already started to reduce cash and buy shares.

We’ll adjust the overall composition of our equity portfolios and sell expensive shares – those that are benefiting from the conflict – and buy cheap shares that have suffered as a result of the war but haven’t lost their ability to perform well, both fundamentally and operationally, when the world returns to a state that we regard as normal.