What does the Ukrainian conflict mean for the future positioning of our investment strategies?
There are many possible outcomes to this scenario. However, it is difficult to predict which one will materialise. However, we have to establish a base case that will determine our future stance regarding the respective asset classes.
We don’t fully agree with discussions about recession or stagflation. Instead, we like to decompose the GDP growth into its constituents. Our economists estimate the economy will still grow by 2% in Europe (this takes into account any second-round effects). In addition, we believe that inflation will stay higher for longer.
Consumer confidence will come down, which will impact consumption. Also, real disposable income will drop as a result of a rising energy bill. We estimate that the momentum will remain positive – households have built up a decent amount of savings and the labour market is recovering well (also in the EU). Of course, we can expect consumers to shift a part of their spending away from discretionary consumption.
Business confidence may also be impacted. Supply chain issues that were improving are back. Some companies have to work out a plan B in order to relocate production from Russia/Ukraine to other regions. We do not expect companies will shelve long-term investment plans.
Governments will go in again by, for example, easing the energy bill. In some countries like Italy and Spain, retail price regulation was already in place but will be further generalised. The EU wants to allow member states to do all they can to help consumers deal with the dramatically inflated gas prices. The EU is also contemplating a windfall tax for companies that benefit from the higher energy prices. We estimate EUR 200 billion will be spent. Therefore, we expect a net fiscal expansion. Member states will have more space to focus on other matters. We will finally get a ‘Big Plan’ for the EU, as it is serious about its” energy independency” this time. Still, don’t expect any quick fixes. A lot of the technologies are still in the research phase. Currently, only nuclear looks like a viable option – be it by building new facilities, or by extending the lifetime of old ones.
Onto central banks: the FED is only worried about inflation and so is the ECB. They have a mandate to get as much as possible on the table and will rather risk a recession than face stagflation.
We discussed a lot of possible outcomes and we finally selected the “escalation” scenario as the most likely. In this scenario, Putin escalates the conflict in Ukraine with heavy bombings on cities and more refugees fleeing into the EU, until Ukraine eventually gives in to the terms of Russia. Important to mention that we believe EU sanctions have peaked. All this means that things will likely get worse before they get better. Financial markets may take another hit when Putin ramps up his military offensive.
Our global sustainable portfolios have a negligible direct revenue exposure to Russia (<1%). Investing globally can lower geopolitical risks.
How did the equity portfolios react to the crisis in terms of performance?
They were not directly impacted by the conflict. As we just mentioned, our direct revenue exposure and cost base in Russia was negligible. However, the impact of the conflict on monetary policy and the economy is more pronounced.
In absolute terms, our equity strategies have been impacted by the correction of the market. But in order to assess the relative return impact it’s interesting to make a distinction between two events that have rocked markets year-to-date.
The first one is the regime shift from central banks. The FED, later followed by the ECB, embarked on a hiking path to fight the high inflation sourced from the post-pandemic demand shock. Steady inflation but rising yields impacted the valuation of long duration stocks and initiated a brutal style rotation from growth factors to value stocks. Although our portfolio managers had gradually installed a barbell approach to mitigate the impact of such a shift, the relative performance of the quality growth strategies took a hit in January. On the positive side, real estate and dividend portfolios benefitted from the rotation.
The second important event started on January 24, when Russia concentrated its troops near the Ukrainian border and NATO put its troops on standby. This provoked an energy shock and resulted in roaring energy prices due to Europe’s high dependency on Russian gas, putting upward pressure on already high inflation figures. However, we haven’t seen rates increasing since the invasion of Ukraine, because potentially weaker business sentiment and consumer confidence weigh on the economic growth outlook. This played into the cards of the quality companies with lower cyclical revenues and less pricing power (unlike banks, some industrials etc). The composite quality names have outperformed the market since the invasion, but still show an underperformance year-to-date. Consequently, the portfolios gained back part of their negative excess, while dividend strategies lost part of their positive excess. Small caps and real estate managed to stay flat or slightly positive in terms of excess performance over the period.
Our thematic/global strategies are subject to different flavours that determine their performance. Whenever conflicts of this kind happen, investors tend to dump the whole category without considering the impact on a company-by-company level. A couple of stock-specific issues aside, these strategies did not recover on relative basis due to their important exposure to Europe. But it also leaves upside, as better company-specific fundamentals should lead to future outperformance.
Were the portfolios subject to any significant changes?
In general, the positioning has not undergone drastic changes since the invasion. The barbell strategy – with focus on highest quality business models and balance sheets – was enhanced to better weather the storm. In our building blocks, the exposure to banks and energy was increased and market sensitivity reduced.
Portfolio construction remains focused on quality. The uncertainty in terms of market directions is too elevated to choose sides yet. Anything can happen in the short term: a victory for Putin will propel the value style. If China joins, we will get a bigger trade war, etc. We don’t see a clear finish line and unlike 2020, there is no FED put that will help us now. Therefore we “bunker” and refrain from making crazy changes to the portfolio-, sector- or style positioning until there is more clarity.
Higher energy prices are putting upward pressure on inflation estimates. Thanks to its tilt towards the US and a focus on quality, we are convinced that the global portfolios are relatively well positioned. We have an important exposure to sectors like IT, healthcare and consumer discretionary that demonstrate relatively stable revenues and high margins. In the meantime, these companies have become cheaper too. Our team keeps its added solar energy exposure as it might benefit from this in the mid-term, and reduced the exposure to IPG Photonics, which has a large manufacturing footprint in Russia. ‘If things get rough, focus on quality’.
In the real estate franchise, now more than ever, the ability to index leases will be important to protect portfolios against inflation. Logistics is a key overweight in the portfolios, because it’s the subsector with the greatest capacity to increase rents thanks to its high pricing power. Also, some companies have a safe-haven status and will outperform, even in turbulent times, which has been the case for Swiss companies for decades. German residential should also be a safe haven. However, it is also seen as a bond proxy and does not live up to the safe-haven expectations due to fears of further rate increases and increasing costs to greenify their portfolios.
We hold on to companies that are constantly working to improve the quality of their balance sheets and increase our allocation to said companies, if appropriate. Typically, UK companies have stronger balance sheets than European companies, like, for example, Swedish firms. The latter are the most levered in Europe and consequently remain underweight in the European Real Estate portfolios.
Offices are more cyclical, and we remain underweight, also due to the remaining low visibility on future demand now that working-from-home is here to stay.
Retail is a strong beneficiary of the re-opening trade on one side but could be hurt by worsening consumer sentiment and retail sales. Meanwhile, as a deep value play, it has a place in our portfolios that maintain a barbell approach. Tactically, we try to use the high volatility to increase and/or decrease this pocket and stay close to neutral in the medium term.
Healthcare is a smaller sub-sector that we continue to like for its long CPI-linked leases even after the Orpea scandal, which is not a game changer in our view.
What about the future positioning of the strategies?
It is still too soon to tell what the conflict in Ukraine will mean for the economic outlook. Although this is not our base case (we still expect 2.5% GDP growth), there is little doubt that the risk of entering a recession has increased as a result of the supply shock. Given the supply shock and based on past experiences from a sector perspective, consumer staples, healthcare, utilities, materials and energy could outperform. Meanwhile, consumer discretionary, industrials, real estate, financials and IT could underperform the market.
The current events have put a long-term risk premium on European risk assets. Foreign flows are very important to support European risk assets, mainly equities. In the past the likes of US investors have been reluctant to invest in Europe due to its political instability. Last year, the European market saw an important inflow from US investors thanks to the combination of a premium on the valuation of US equities, Europe’s catch-up potential after the pandemic and its value content. US investors will not come back anytime soon. But at the same time, it will be an important catalyst for a further consolidation in European fiscal-, defense- and energy policies. This will provide less breeding ground for Eurosceptics and can lay the basis for a sounder recovery in European equities.
Our investment style implies that we are well positioned in quality companies with strong balance sheets that have demonstrated pricing power in the third and fourth quarters, benefit from structural drivers going forward and with self-help potential to weather the storm.
Geographically there is a preference for US equities due to their low exposure to the EU economy. The US is also more defensive and less exposed to the conflict and its challenges ahead. We are convinced that our global portfolios are relatively well positioned. Other regions are more interesting in terms of valuation but are more linked to the cyclical exposure of the market. Due to the higher uncertainty, we also prefer quality over the value style. When things get rough, we stick to quality, which is in line with our natural investment bias.
The quality growth style is, and remains, the core of DPAM’s DNA. We refrain from reacting to short-term movements in the market and stick to a longer-term view. We are convinced that companies that can continue to grow in a difficult economic environment (one driven by investments rather than monetary expansion) are the way forward.
