The last few weeks have been unsettling for all. Russia’s decision to invade Ukraine set off a raft of retaliatory measures by western allies that caused the ruble to halve in value. Russia’s financial institutions were shut out of the SWIFT interbank network, and many will fail as they are unable to settle liabilities.
On the ground Putin faces a drawn-out war as his forces have been thwarted in their initial advance. Our thoughts and prayers are with the Ukrainian army and the countless civilians now fleeing hostility. The financial world for much of this year has been trying to discount the likelihood of war and its impact on inflation vis a vis oil prices. Now that the impact is better understood, financial markets have started to discount a slower rate of monetary tightening by policy makers. The Federal Reserve is expected to start raising interest rates in two weeks. Expectations of a 50-basis point hike in March have quickly evaporated as war related uncertainty argues for a softer approach.
Source - Bloomberg
US 2-year yields, highlighted in the chart above, peaked at 1.6% just before the war started. 2-year yield are now 1.38%. While inflation pressures have accelerated due to higher oil prices, financial markets now expect the Fed to moderate its rate hiking cycle. Note that financial conditions play a key role in equity market behaviour.
Bonds have started to rally and are now fulfilling their safe-haven role within multi-asset portfolios. The other safe-haven asset, the US dollar, has also rallied versus sterling. This rally has helped protect portfolios due to our US dollar allocations.
The table below shows the performance of the funds held within core growth portfolios. Global infrastructure allocations have done well as their underlying exposures, non-cyclical sources of inflation linked revenues, have been unaffected. Our allocation to infrastructure has increased in 2022 and we believe the asset class provides a ballast for portfolios in an uncertain macro environment.
Broad equity indices declined in February, with European equities and UK Mid-caps leading the decline. Chelverton UK Equity Growth and Marlborough European Special Situations have been the largest detractors. Both funds have a small-cap focus and have fallen victim to broadening risk aversion. Both funds are well run, with a long-term track record of active outperformance. We are in constant contact with both teams and feel the sell-off creates an attractive forward-looking opportunity for both managers. While equity markets are likely to remain volatile, the outlook for corporate profits remains robust.
Our fixed income holdings have been under pressure due to central bank hawkish rhetoric. Recent developments have led to a reduction in policy concerns which has supported bond prices. Our gilt and global bond holdings have done well in recent weeks.
Our allocation to multi-asset funds has been a detractor over the month. While these holdings are small in relation to our fixed income and equity exposures, we appreciate the downside risk they face. Our two holdings, Sanlam Multi Strategy and Atlantic House Total Return, both have a systematic risk reduction process when faced with increased volatility. While this does not eliminate drawdowns, it helps limit significant falls.
Our approach in 2022 has been to cut sources of unintended risk. By removing Emerging Market exposure and reducing Asia and high yield allocations, we have reduced geopolitical and currency risk with our portfolios. We have significantly increased our exposure to US dollar assets through our fixed income and equity allocations. Finally, we have increased our exposure to quality assets by increasing global infrastructure. We have pre-emptively reduced unwanted sources of risk within portfolios enhancing our ability to weather increased volatility. Note that these steps were taken before the onset of Russian hostility.