Russia’s invasion of Ukraine is the latest in a series of adverse developments affecting the global economy and the financial markets.
Since October 2021, we have become increasingly concerned about the market situation. At the time, we realized the
significance of the developing inflation pressure and its potential adverse market impact as companies struggle to raise prices and maintain margins while investment assets are repriced as interest rates are raised.
At the time, we were surprised by the extent to which the market seemed oblivious to the developing risks. We reviewed all the portfolios and reduced equity investments in those where it was at the top range of the targeted exposure. While the markets continued to go up until the end of the year, our call has proven prescient as markets are down almost 10% in the meantime.
Historically, short of world wars, geostrategic events did not usually affect financial markets in a lasting manner. While such events can be spectacular and generate headlines, markets are usually much more affected by changes in macroeconomic trends such as interest rates, inflation or socio-political developments.
However, coming on top of the inflation and interest rates threats, the Russia-Ukraine war further exacerbates them and creates an even more challenging situation. The main way it may impact financial markets is through the oil prices. Sanctions on Russia could worsen even more the current supply shortage leading to higher prices. This would increase the inflation risk on one side but also, on the other side, the risk of a recession-driven by demand destruction due to excessive prices.
Basically we could face three types of scenarios. The first is a continuation of the current inflationary pressure combined with economic growth which is the “least bad” scenario. The second one is a weakening of the economy or possibly even a recession combined with reduced inflationary pressure which would offset to some degree the weak economy. The third and most adverse scenario is stagflation which combines economic weakness and inflation.
The parameters at work are so complex that it is not possible to predict which scenario will develop. In practice, investors need to mitigate, to the extent possible, each of these risks. The inflation makes this task particularly challenging as being in cash, usually the most conservative solution, has a high cost as money is losing its value.
Diversification (in the true meaning of the word, between different asset classes!) is essential. Exposure to investments that are likely to do relatively better in the current environment is important too. Healthcare stocks are usually resilient and have catch-up potential after recent underperformance. Financial stocks can benefit from increases in interest rates. Real estate, retail and commodity stocks can benefit from inflation. Macro hedge funds can structure trades that take advantage of the current volatility, as well as other hedges fund strategies such as volatility traders and arbitrage funds
While we would like to share a more upbeat message, the reality is that the next weeks and months are likely to remain difficult for the markets. Having implemented in all our portfolios the measures suggested above, we believe that the current balanced approach should limit the downside even under adverse scenarios. While the current market levels do not provide a particularly attractive entrance point, a further correction is likely to provide interesting opportunities in riskier assets.
As always, the challenge of investment management is the uncertainty and complexity of the economic environment. As investment managers, we are in a constant search for the optimal balance between risk and opportunity, audacity and conservatism and this is what we are seeking to do to the best of our abilities in the current circumstances.
We are available to discuss further any time.
With kind regards,
Ilan Weil, CIO
Orit Raviv Swery, Founder & CEO