This episode’s roundtable discussion features a deep dive into the Russia-Ukraine War from a fixed income, equity, and multi-asset perspective. George Bory, managing director for Fixed Income Strategy and Product Specialists for Allspring Global Investments, speaks with Ann Miletti, head of Active Equities, and Matthias Scheiber, global head of Portfolio Management for the Multi-Asset Solutions team.
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George Bory: I’m George Bory, managing director for Fixed Income Strategy and Product Specialists for Allspring Global Investments, and you’re listening to On the Trading Desk®.
Today, we’re taking a deep dive into the Russia-Ukraine War and the implications it’s having across asset classes.
Joining me in this roundtable discussion is Ann Miletti, head of Active Equities, and Matthias Scheiber, global head of Portfolio Management for the Multi-Asset Solutions team. Thank you both for being here.
Ann Miletti: Good to be here. Thanks for having us.
Matthias Scheiber: Thanks for having me, George.
George: Thanks, Ann and Matthias. I’ll kick us off and frame out the discussion.
Russia’s invasion of Ukraine was by far the most significant event of this year. Thousands have been killed and millions have been displaced while much of the world’s geopolitical structure has been thrown into question. Long-standing alliances are under strain, and new ones are being forged.
The economic consequences have been devastating for Ukrainians, while ordinary Russians bear the brunt of strict international sanctions. For the rest of the world, supply shortages and supply chain disruptions extended across the energy complex, throughout the grains markets into metals and chemicals, pushing commodity prices higher and restricting the availability of critical parts, goods, and supplies for many manufacturers and consumers around the world.
Now economists can be clinical about what’s happened. They look at the physical destruction and corresponding spike in prices and they expect that to detract at least 1% from global growth this year, with the brunt being borne by Eastern and Western Europe.
But it’s really hard to overstate the political and financial repercussions of this conflict, much of which remains to be played out, but perhaps the most important part for financial markets has been the Fed’s (Federal Reserve) reaction to the economic fallout from the conflict and their shift to a much more hawkish stance.
In my 30-year career, I have never heard such strongly hawkish commentary from Fed officials. It seems they view inflation as a clear and present danger and they are staking their credibility on their ability to restore price stability to the U.S. economy.
Debt markets have responded aggressively. The Fed Funds market now prices in 250 basis points of rate increases over the course of 2022. And with just six meetings left this year, this suggests at least a few 50 basis point rate hikes.
And to no great surprise, the entire fixed income market has undergone a massive rotational rebalancing to adjust to duration positions to reflect the brave new world of higher inflation and a more hawkish Fed.
Now further out the yield curve, yields have risen quite a bit, and the curve yield has flattened. Just looking at the Treasury market, yields in the overall Treasury market, they’re about 120 basis points higher so far this year, which has resulted in year-to-date mark-to-market loss of more than 6%, and that pretty much marks the worst start to the year for the fixed income markets on record.
So the question really is where do we go from here? We’ve seen a seismic shift in expectations and a huge disruption in the political backdrop, neither of which can be understated. But it’s our view that much of the repricing in the fixed income market, while painful, has been very much necessary.
Today’s market better reflects the current economic backdrop and should allow credit to flow thru the system in a more orderly and efficient manner. The reality was, and is, that the extraordinary monetary policies implemented in 2020 in reaction to the COVID crisis were simply not sustainable.
The economic reality is inflation will be higher, growth will be slower, and monetary policy will be tighter. Supply chains need to be reworked, and the globalization trend that have really lifted many boats over the past two decades will continue to slow, but that does not mean a recession is imminent.
There will be winners, there will be losers, and it’s our job as investors to identify those two types of investments.
In the coming months, it basically suggests to us that interest rates will continue to head higher, as they continue to recalibrate, but at a much slower pace than we’ve seen in Q1. The wild card, in our opinion, is with credit spreads.
Much of this year’s repricing appears to reflect the need to shed duration in the face of high inflation and a less accommodative Fed. Current credit valuations are more consistent with mid-cycle growth rather than fears of a hard landing.
Now we have sympathy with this view, but we’re also uncertain about the pace at which tighter financial conditions will impact the real economy and the borrowers in the market who need to borrow money going forward.
So in our fixed income portfolios, we’ve started to pivot to a more, what we could call, debt-friendly stance. It means rates can go up, but there’s enough cushion in the market to offset some of those mark-to-market losses. And pockets of value have started to emerge in certain segments of the market and we’re trying to adjust portfolios accordingly.
And right now, we basically have a three-pronged approach. The two-year Treasury does start to look attractive to short duration cash-related investors, so some value’s been created in the front end of the curve.
In the intermediate part of the curve, credit spreads now look relatively attractive. And with premiums now meaningfully repriced, we think there is some opportunity to add value to investment grade credit. And then lastly, at the long end of the curve, the recent upsurge in volatility has meant long-duration municipal bonds now, in some instances, have yields that are in excess of Treasuries.
Municipal bond investors tend to be individual investors. The tax advantage for municipal bonds works quite nicely for individual investors. As those investors have reduced duration, they’ve actually forced down the price of many long-dated muni bonds so that they’re actually wider or cheaper than their respective treasuries.
So while we’re not saying it’s time to rush out and buy all the debt out there or move to an aggressively positive stance, our message is one that the volatility of the first quarter has created some relatively attractive opportunities for fixed income investors to earn yield, to earn income, and to weather what we think will continue to be a volatile market, but perhaps not quite as volatile as we’ve seen in Q1.
And so with that, I’d like to turn it over to Ann to talk a little bit about the equity markets where volatility has also been pretty significant. And maybe you could talk a little bit, Ann, about the difference between, say, growth and value. Growth and value is a typical way for an equity investor to think about the markets. Is that still the right style approach when we think about the major changes we’ve seen and the possibility for ongoing volatility?
Ann: Thanks, George, for the question and for the great introduction to all of these topics.
Certainly, volatility has been the theme of the year, and across almost all capitalization ranges, we’ve seen a pretty dramatic shift in rotation from growth to value, especially over the last 18 months. This wasn’t a surprise as we’ve moved now into part of the business cycle that favors more value-like industries.
However, I think we’ve reached a time where it’s becoming increasingly difficult to choose a winning category. It’s going to be more essential to focus on individual companies themselves and, in some ways, the current war is only exaggerating this point. What is happening there is truly tragic for the people of Ukraine.
As we look at this and other events across the globe and then focus more on the investment side, you can see areas of the market that would be deemed to be value, such as energy and material companies, producing outsized gains.
Now energy and other commodities were already starting to show their strength prior to the war, given some of the inflation concerns that you talked about, George. But the war layered on another level of concern related to greater supply shortages.
Certain financials have also benefited. This is also another area of the market that people would categorize as value, and that’s because investors understand that we’re moving in a completely different direction. Interest rates are no longer low and going lower. We’re moving higher. And the Fed, like you told us George, they’ve told us that we’re going to see numerous rate increases this year. Rates going up are positive for banks. They make loans more lucrative and deposits more of an asset. But here’s where we need to be careful.
There are other areas deemed to be value that are likely to see a lot more pressure. Consumer staples and industrials, for example, both are areas that have a lot of inputs. With rising energy and commodity prices, those input costs are rising at a really rapid pace and it’s likely to become more difficult for those companies to pass along the price increases to their customers. As higher inflation, though, begins to start slow growth, our investment teams understand that what companies can control is not just input costs, but they also need to focus on what companies can’t outgrow the economy, the broader economy, and also their competitors.
And that’s why we’re less focused on picking a category at this stage, but really focused on picking the right companies to invest in. And I think this shift is actually one that benefits one of our core strengths as a company and that’s focused on active management. We have great active fundamental investment teams that are focused on stock selection. And so some of these changes, although difficult when you can’t just pick one area of the market, I do think benefit us at Allspring.
George: Okay. Thanks, Ann. That’s really great. Now maybe we can pivot over to Matthias, who can talk a little bit about, in detail, some of these supply chain issues, how it’s affecting volatility, and how investors should think beyond both equities and fixed income but think about the markets in totality.
Matthias: Thank you, George, and really good comments on the situation.
From a multi-asset perspective, the primary channel we have seen in terms of global impact was high volatility with short-end commodity volatility increased four-fold. We saw huge spikes in commodity prices, not only in energy, but also agriculture. Both Russia and Ukraine are big agricultural exporters. And when we talk about the supply chain issues, as you mentioned, as well, George, there are some underlying price pressures continuing. Think of fertilizer prices, which are actually still continuing to rise, so this is all likely to put pressure on commodity prices. This led to higher inflation expectations on top of already high inflation levels.
What this did to markets that also started then to impact equities and bonds at the same time was it’s basically softening the Fed Put, meaning it’s harder for central banks to intervene to calm markets with additional liquidity. In contrast, their tightening of 2.5% of further rate hikes price is pretty aggressive, given where we are coming from.
And what this did is it led to a positive correlation of equities and bonds at the same time. So that then led to a higher risk aversion, wider credit spreads, stronger dollar, liquidity tightening by the private sector on top of what the Fed was already planning to do. So that was kind of a vicious cycle that further increased volatility in markets.
So the way to position yourself, or on our side, is to think of it from two angles. One is the strategic angle. There we have an inflation exposure as a building block in our long-term asset allocation, which performs especially well in a strongly rising inflation environments because those environments have the potential, as we’ve seen lately, to impact equities and bonds both negatively at the same time. It is worth saying, though, that that strategic inflation exposure has a lower weight, a smaller weight, than the equity and the bond allocation because if you think of it is as true inflation protection, the protection should ultimately cost money and that’s what you see long term in some of the negative carry and in some of the commodity markets, for example.
Another way to position strategically is also to redefine what is actually defensive exposure, because in that inflation environment, you would have thought maybe the bonds helped me if the equities sell off, but with higher rates expectations, that didn’t really work out. But, for example, a long dollar exposure instead of long bond exposure can have a similar defensive character in tail events and especially works also in a high inflation environment.
Tactically, there are ways we can refine our exposure with the help of underlying equity managers. As Ann mentioned, our research has, for example, shown that value as a strategy tends to react positively to inflation surprises. That’s what we’ve seen, and we’ve seen some of our growth and momentum strategies in our portfolio struggling a bit more in this environment. This is one way to navigate away from it, shorten the bond duration in the allocation. And commodities is probably still one of the purest plays. And last but not, with the high volatility, we have also seen some of our systematic equity downside risk management strategies triggering earlier this month, so they have started to hedge, basically, some of our equity exposure.
George: Matthias, that’s great. Very, very important. As you mentioned, high vol and duration management remains front and center for many of our clients. And the reality is that’s not going away anytime soon. It’s going to be a challenge throughout 2022 and I think beyond.
So Ann, let’s bring it back to you. Contagion is a real risk. Russia’s influence on the global markets is significant and rapidly impacts many corners of the market. What are some of the outstanding risks that we’re managing against, especially as it relates to the spread of this constant stream of negative news that seems to be coming out of the conflict?
Ann: George, I have to chuckle a little bit when you asked that question because as a former portfolio manager myself, I’m always and have always been focused probably more on risk than reward and that might surprise people. And so it’s really taken a lot of time to really focus on the value of volatility and the true rewards of following an investment process that can control emotions, really take emotions out of decision-making.
So rather than just focus on all of the negatives, I think it’s really our job right now to focus on looking at the world through a magnifying lens and looking at companies through a magnifying lens, not a telescope.
And so volatility is likely to continue across all asset classes, categories, and industries, but we need to be focused much more on company-specific risks, and that’s why our investment teams are doing. And so I don’t know what the next big black swan event is going to be across the globe, but if we stay focused on our investment processes and company-specific risks, that’s going to lead to better outcomes.
Also, trying really hard to take advantage of volatility. Very often, people outside of our business think about volatility as a negative thing. If you just look at the very definition of it, it’s not necessarily a positively inclined word. But in our business, volatility and taking advantage of it can bring a lot of reward.
And so we’re looking specifically for companies with strong free cash flow, strong competitive advantages—meaning do they have innovative products and solutions? Do they have management teams with deep experience that have operated through volatile and difficult times in their past? Those are some of the things that our investment teams really focus on. They’re really doing a lot of deep dives on in their portfolios and always have.
There could be short-term challenges for all of these companies, but again, we’re going to take the magnifying lens approach now, not the telescope, and I think that’s going to lead us to better returns for our investors.
George: Thanks, Ann. The magnifying lens versus the telescope is absolutely the right way to think about it and using volatility as a positive. Matthias, any final words from you?
Matthias: Yes, thank you, George, and I fully agree with Ann’s statement. Basically, it will be very hard to predict what happens next. Focus on the risks. Stay diversified.
In the case there’s further escalation, there might be some hedges that previously didn’t work that might work going forward because they’re now much cheaper. Think of long yen, some of the currency trades, like long Swiss franc.
Maybe at some point even the bonds, once the interest rate hikes are aggressively priced, and as Ann said, there might be good opportunities in equity markets where investors need to be careful in what stocks they pick.
But if some of the geopolitical risk comes down, then looking at companies that can deal better with higher rates and high inflation and with a strong balance sheet, I think that makes a lot of sense that there will be good opportunities and good hunting grounds in the equity market again, as well.
George: Ann and Matthias, thank you very much for joining me today and discussing this rapidly-changing situation and the effects it’s had on the markets and the global economy.
Ann: Thanks, George.
Matthias: Thank you, George. Much appreciated.
George: That wraps up this episode of On the Trading Desk. If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com.
To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you get your podcasts. Until next time, I’m George Bory and thanks for listening.
Disclosure: All investing involves risk, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics. 100 basis points equals 1.00%. Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.