NN IP: Geopolitics impacting investor risk appetite

NN IP: Geopolitics impacting investor risk appetite

Risicomanagement Rusland Politiek
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By Maarten-Jan Bakkum, Senior Emerging Market Strategist, NN Investment Partners 

Investors remain nervous about inflation and hawkish central banks, but it’s been the tensions over Ukraine that have unsettled them most over the past week. This has been reflected in oil hitting new highs and another leg down for global equities. 

The concerns are mostly about the potential for a prolonged period of geopolitical uncertainty in which oil prices could rise even more or at least remain high. This would worsen the inflation problem, possibly forcing central banks into another hawkish shift. Such a development could be particularly painful for the Eurozone if it triggers a rapid widening of peripheral spreads.

We are positioned for further disappointing inflation figures and faster monetary policy tightening through an increased underweight in US Treasuries and an underweight in German Bunds, and in particular through our large underweight in Italian government bonds. During the week we moved moderately overweight in copper.

The Ukraine problem looks unlikely to go away in the short term

It’s difficult to predict Russia’s next steps. A full-scale military invasion of Ukraine looks unlikely as it would require more troops than are currently massed near the border. What’s more, the costs of an occupation of Ukraine, in terms of both lives and roubles, would be enormous.

If Russia were to take military action, it would probably be through a focused attack on east Ukraine, carried out under the flag of the Donbas separatists. This would enable Russia to deny responsibility for the action while still provoking a political crisis in Ukraine. Ultimately, Russia’s main aim is to weaken Ukrainian President Volodymyr Zelensky’s government and lay the groundwork for a new regime that would act in the interests of the Kremlin and drop Ukraine’s ambitions to join NATO or the EU.

For now, military escalation has not been priced in by the markets. Rather, it’s the uncertainty about energy prices that has caused the risk aversion among investors. Unsurprisingly, Russian assets – particularly equities – have suffered the most, with the Russian equity index down by almost a quarter since November as investors have discounted the increased risk of new Western economic sanctions.

But over the same period, the rouble has underperformed other emerging currencies by just 4 percentage points. The main reasons it has held up relatively well are Russia’s strong current account and government balances, with the broad economy and banks not dependent on foreign funding.

What’s more, the Bank of Russia is one of the most orthodox central banks in the world: over the past 12 months it has raised interest rates by 5.25 percentage points and it has accumulated USD 240 billion of international reserves over the past five years.

Thanks to its strong balance sheets and limited external exposure, the Russian economy is well placed to deal with sanctions. The Russian economy would take a serious hit if the US and Europe were to ban all imports of Russian oil and gas, but with Russia the main supplier of energy to Western Europe, meaningful energy sanctions of this kind look unlikely. This gives President Putin scope to go about trying to fulfil his geopolitical ambitions.

We have seen few signs that diplomacy is working, with Russia claiming that its key security demands remain unanswered. This makes it difficult to see how the tensions will ease.

Positioned for further tightening

We further increased our exposure to rising interest rates in our multi-asset model portfolio by increasing our underweight in US Treasuries from moderate to large. We maintained our moderate underweights in German Bunds and local-currency emerging market bonds. We also kept our large underweight in Italian government bonds and moderate underweight in Eurozone investment-grade credit in place as we anticipate an early end to the ECB’s net asset purchases.

Several ECB Governing Council members have been saying that the first rate hikes will come in the second half of the year, which implies that asset purchases will probably end sometime in the summer. This is likely to have a significant impact on the supply-demand balance for Italian debt. And with 28% of the ECB’s net asset purchases allocated to investment-grade corporate bonds, we believe the spreads of this asset class could widen further.

No changes to our equity allocation

We remain neutrally positioned in global equities. The backdrop remains challenging for equities, with high inflation translating into higher global bond yields and the Ukraine situation impacting investor sentiment. Meanwhile, the Q4 earnings season in the US is coming to an end. Earnings have increased by 26% on average, 6 percentage points higher than expected.

Technology and financials firms have provided the biggest positive surprises, although their strong results have been tempered by more cautious outlooks. Corporate margins are coming under pressure due to a rapid rise in input costs that cannot be fully passed on to customers through higher prices. Another consideration is that rising energy prices are likely to eat into households’ disposable incomes.

Within equities, we remain overweight in the Eurozone and China. We like Chinese equities based on the expectation of further policy divergence between China and the rest of the world as there have been further indications that the authorities are stepping up their stimulus efforts.

We also expect the government to recalibrate its Covid policies, moving from zero-tolerance to a gradually less stringent approach. On a sector basis, we remain overweight in financials, energy, materials and industrials, and underweight in communication services.

Moved overweight in copper

We end this week’s edition of the Houseview by highlighting a change in our commodity allocation: last week, we moved moderately overweight in copper. Over the past few months, copper has underperformed in the industrial metals revival, mainly due to the real estate crisis in China. Copper is strongly correlated with Chinese credit growth, which is an important forward-looking indicator of construction activity and looks set to increase as the Chinese authorities prepare to ease monetary policy further.

As a result, we moved overweight. New measures to restore confidence in real estate should help sales and prices in the sector, which will be key in kickstarting a recovery in construction activity. More public housing and infrastructure investments should also result in increased demand for copper, while there is normally a seasonal recovery in housing demand in the months following Chinese New Year.

Copper inventories remain close to a multi-year low (see figure). With a restocking cycle likely in developed markets, an expected pick-up in Chinese demand and easing supply constraints in global manufacturing, copper inventories could fall even more. Meanwhile, there are still concerns about production, with a new road blockade at the China-owned Las Bambas mine in Peru, which accounts for 2% of global supply, and ongoing discussions about possible nationalization of copper mining in Chile.

Copper inventories

16022022 NNIP

Source: Refinitiv Datastream, NN Investment Partners

Over the medium term, copper should be a key beneficiary of major investments to limit climate change. The metal is one of the best conductors of electricity, is almost 100% recyclable and is vital in new power grid infrastructure, energy-efficient electric devices, wiring, electric vehicles and wind and solar power. It’s been estimated that a fully renewable energy infrastructure would require 12 times more copper than is used in the current energy infrastructure.