How To Deal With All Of This, All At Once

How To Deal With All Of This, All At Once
Reda Farran, CFA

almost 2 years ago5 mins

  • The three themes currently dominating markets are soaring inflation, rising interest rates, and the Russia-Ukraine conflict.

  • You could respond by reducing your exposure to growth stocks and investing in sectors that can more easily pass on higher costs to customers instead.

  • You might also want to consider reducing your exposure to government and corporate bonds, and investing in inflation-linked bonds, loans, gold, and new energy commodities.

The three themes currently dominating markets are soaring inflation, rising interest rates, and the Russia-Ukraine conflict.

You could respond by reducing your exposure to growth stocks and investing in sectors that can more easily pass on higher costs to customers instead.

You might also want to consider reducing your exposure to government and corporate bonds, and investing in inflation-linked bonds, loans, gold, and new energy commodities.

Just when we thought we were out of the frying pan of Covid, we’ve flopped gracelessly into the fire of another three predicaments: geopolitical aggression, astronomical price rises, and newly hawkish global central banks. It’s a lot of heat for one portfolio to take. So let’s revisit how things are going, and take a look at a few ways to make sure you don’t get burned.

1. The Russia-Ukraine conflict

Russia is a commodities powerhouse that exports huge amounts of the materials the world uses to build cars, transport people and goods, feed populations, keep the lights on, and more. So the conflict – and the West’s subsequent sanctions on Russia – have caused a commodity supply shock that’s pushed up their prices to new highs. That’s set to increase global inflation even more at a time when it’s already at multi-decade highs in large parts of the world.

Europe is being hit particularly hard considering it imports the majority of its energy from Russia. I’m expecting the resulting shock to catalyze a major shift in Europe’s energy policy in two main ways. First, it’ll likely move away from Russian gas transported by pipelines to liquified natural gas (LNG) from nations like Australia, Qatar, and the US. Second, the continent will most likely look to accelerate its shift to renewable energy coupled with battery storage.

Finally, many countries depend on imports from Russia and Ukraine for their food needs. North Africa and the Middle East, for example, import over 50% of their cereal needs and a large share of wheat and barley from the countries. Consider, then, that rising food prices in 2010 were one of the catalysts of the “Arab Spring” uprisings that turned violent in many countries, and you can start to see how the current situation could again lead to social unrest in the region, as well as other parts of the world.

2. Inflation

With inflation rates at multi-decade highs in large parts of the world, the question now is where we go from here. I’m envisioning three possible scenarios.

The bearish scenario is that we get spiraling inflation. This is where rising prices of goods and services push employees to demand higher wages, which leads to increased spending and higher inflation. This is only getting worse as companies raise the prices of their goods and services to offset higher wage costs. This loop leads to higher and higher (i.e. spiraling) inflation.

The base case scenario – that is, the consensus view – is that we enter a period of stagflation, where economies simultaneously experience high inflation and low economic growth. That’s because rising prices, which are being caused by soaring material costs, dent consumer spending – a key driver of economic growth.

The bullish scenario is things normalize and inflation drops to more bearable levels. That could be down to a resolution of the Russia-Ukraine conflict, a permanent fix to the world’s ongoing supply chain issues, and so on.

3. Central bank policy

Rising inflation and falling economic growth puts central banks in a bit of a pickle, with many of them trying to engineer “soft landings” for their economies – that is, cooling their economies down while avoiding a recession. If they hike interest rates too slowly, they risk allowing inflation to run out of control. In fact, some critics already think central banks are behind the curve in tackling soaring prices. On the other hand, if they hike too quickly, they could end up roiling markets and tipping their economies into recession.

The Fed said last week that it’s preparing to hike interest rates by 0.5% – double the typical 0.25% – at its next meeting. In fact, according to the futures market, US interest rates are expected to increase by 1.85% by the end of the year. That means the Fed – which only has six meetings left this year – is likely to raise rates by that margin not just once, but multiple times. That would mark one of the fastest and most aggressive set of rate hikes in recent history.

Source: Bloomberg
Source: Bloomberg

The futures market is pricing in 7.4 more rate hikes this year (in 6 remaining meetings), implying short-term rates will increase by a further 1.85% to 2.20%.

How should you adapt to these three problems, all at once?

1. Adjust your stock portfolio

Consider lowering your exposure to expensive-looking growth stocks, which are a lot more sensitive to rising interest rates. Instead, look to potentially increase your exposure to sectors that can more easily pass on higher costs to customers, like consumer staples, utilities, medical devices, and energy. Finally, think about investing in cheap-looking markets that should perform well if their valuations normalize. Chinese stocks, for example, are trading at their biggest valuation discount to global stocks on record.

Chinese stocks’ forward P/E ratio compared to global stocks’. Source: Bloomberg
Chinese stocks’ forward P/E ratio compared to global stocks’. Source: Bloomberg

2. Adjust your bond portfolio

Global bonds, both government and corporate, are currently experiencing their worst drawdown on record. Government bonds’ fixed future payments become worth less when inflation is on the rise, after all. Similarly, falling economic growth dents companies’ profits and increases the risk that they won’t be able to pay back their debt. That gives corporate bonds a knock. So if we do enter a period of worsening stagflation, it’s best to avoid government and corporate bonds that would only continue to underperform.

Which parts of the bond market should you invest in instead? Two options. First, inflation-linked bonds, whose principal and interest payments rise and fall with the rate of inflation. Second, loans, which tend to have floating interest rates. That means the interest they pay investors heads higher when rates rise. As far as fixed income investments go, loans are actually some of the best hedges against rising interest rates.

3. Adjust your commodities portfolio

One of the best ways to position your portfolio for a potential stagflationary environment is by investing in gold. Investment firm Schroders has calculated the average real (inflation-adjusted) annual total return of major asset classes since 1973 during different economic phases. The number one performer during periods of stagflation? Gold.

Asset class performance during different economic phases. Source: Schroders
Asset class performance during different economic phases. Source: Schroders

This makes sense. Gold is often seen as a safe-haven asset that tends to do well in times of economic uncertainty. Real interest rates also tend to fall in periods of stagflation, which reduces the opportunity cost of owning a zero-yielding asset like gold, boosting its appeal to investors.

Finally, if Europe is expected to accelerate its shift to renewable energy and battery storage, then consider investing in the commodities exposed to these areas – namely lithium, nickel, copper, aluminum, and polysilicon.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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