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How Should Investors Alter Portfolios Considering the War in Ukraine?

Kevin Rosenbaum, CFA, CAIA

Thoughtfully, if at all. Russia’s invasion of Ukraine sent shockwaves across the world, creating a tragic humanitarian and geopolitical crisis, and introducing new uncertainty to the global economy and financial markets. The lynchpin to understanding how assets may perform in the coming days and weeks is, of course, knowing the duration of the war and its impact on the global economy. Sadly, the situation is far too fluid at present to have real confidence in any assessment. So, the best advice for most investors at this stage is to examine portfolio risks related to the war and monitor market developments.

To understand portfolio risks, investors need to know what they own. In this case, how much exposure does the portfolio have to Russia, Ukraine, and Belarus, from direct investments in them, revenues tied to them, and any other linkages? The revenue exposure of the MSCI All Country World Index (ACWI) to Russia, Ukraine, and Belarus is 1%, as of February 28, 2022. At that time, Russia was the only country in the index, with a weight of 0.2%. But MSCI will remove Russia from the MSCI ACWI at a price that is effectively zero on the close of March 9, 2022. 1 And, is this exposure materially different from portfolio benchmarks? Investors should also consider the liquidity terms of the products with these exposures to understand what could be changed in the near term if a spending, rebalancing, or tactical need arose. At the same time, it can be helpful to engage investment managers to understand how they are responding and how exposures may shift in the future. Stepping back though, cutting investment managers because of underperformance alone, particularly in periods of high market volatility, is rarely a good decision.

Beyond direct risks, there are also indirect risks related to the war that could more meaningfully affect portfolios. A prominent one is, of course, potential further increases in the rate of inflation. Yesterday, new data revealed that euro area inflation hit 5.8% in February, which was higher than analyst expectations (5.6%). European gas prices have surged more than 50% in March, as a growing reluctance to do business with Russia collided both with already-low inventories and the fact that Russia supplies Europe with more than 40% of its gas. Some suggested near-term plans to avoid an energy crunch, such as increasing liquefied natural gas imports to existing European facilities, reopening coal-fired power plants, and keeping existing nuclear power plants online, would likely still leave a hole in energy supply for the Continent. Beyond energy, pressures are also apparent in agriculture and base metals, given the importance of Russia and Ukraine to global supplies.

Another prominent indirect risk relates to economic growth. Large increases in energy and food costs reduce disposable incomes available for consumption in other industries, and they sap consumer and business confidence, both of which can erode economic activity. Global companies may also be buyers of raw or intermediate goods produced in Russia, Ukraine, or Belarus, which could impact their ability to deliver final goods to markets. While these facts threaten the path of global economic growth, Europe is most at risk, given the greater connections it has to countries involved in the war, with emerging markets commodity importers also vulnerable. Federal Reserve Chair Jerome Powell emphasized the threat to economic activity just yesterday in testimony before Congress, saying “the near-term effects on the US economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain.”

How expectations related to inflation and economic growth evolve will likely dictate the direction of asset prices to a greater extent than is typical and warrant close monitoring. While typically the drop in aggregate demand associated with a growth slowdown impacts price levels to such an extent that inflation rates fall, the impact of this crisis on the supply-side of the economy has increased the possibility of a stagflation scenario, even if it remains unlikely. Scenario testing a portfolio using returns associated with extreme events, such as the 1970s energy crisis or the global financial crisis, can help identify diversification gaps, equity beta mismatches, unintended duration bets, or inadequate liquidity to meet spending and capital call requirements. It is also a good idea to consider the degree to which safe assets are safe —not all cash is stable in a crisis and credits won’t hold up as well as high-quality sovereigns.

Ultimately though, positive excess returns are difficult to achieve in a portfolio, but very easy to lose. Guarding against rash decision making is key to long-term outperformance.

Footnotes

  1. The revenue exposure of the MSCI All Country World Index (ACWI) to Russia, Ukraine, and Belarus is 1%, as of February 28, 2022. At that time, Russia was the only country in the index, with a weight of 0.2%. But MSCI will remove Russia from the MSCI ACWI at a price that is effectively zero on the close of March 9, 2022.