What the War in Ukraine Means for Asset Allocations

18 March 2022
23 min read

The war in Ukraine has changed so many aspects of the investment outlook—from the policy environment to macro and market indicators—that it might seem overwhelming to investors. AB is deeply saddened by the tragic events, and the lives of all those impacted are very much on our minds.

But in addition to acknowledging the human pain, investors must also make strategic decisions in response to the changing landscape. The situation is moving so quickly that it’s hard to outline a clear, step-by-step path. But we can identify aspects that should be the core focus of the short-term and long-term response, which provides some framing for thinking about portfolio positioning.

Even before this war started, we saw an urgent need for investors to boost inflation protection in their portfolios—a need that’s redoubled given current events. The inflation narrative has also changed: rather than a transition from very high near-term inflation to merely moderate longer-term inflation, there is an overt flavor of a 1970s-type increase in input prices. We don’t think this will be short-lived.

Moreover, the current situation further elevates the longer-term inflation narrative by speeding the onset of a less globalized world. The prospect of deglobalization has both a direct impact on portfolios, via inflation, and second-order effects on diversification. If the great wave of disinflation since the early 1980s was driven by demographics and globalization, both of those forces are now firmly in retreat.

The growth outlook is the other key focus, in terms of both the immediate impact of higher input prices and the more serious risk—in Europe at least—of an energy shortfall and potential rationing, which would directly impact production. This development would likely be met with fiscal support; we’re just starting to discern its outlines, but the pandemic experience makes it much easier to contemplate.

The portfolio response must be to intensify the focus on hedging inflation.

In our previous research (Assessing the Inflation Trajectory—and Portfolio Responses), we distinguished between inflation hedges in moderate-inflation and high-inflation scenarios. Short-term inflation is very elevated and could stay that way for a year or more. However, the longer-term picture still has inflation elevated but not unanchored, because deflationary forces are still in place (however remote they seem right now). Over the longer horizon, equities, certain factor strategies, select private assets (such as private debt) and physical real assets should form a core part of portfolios’ inflation component.

Aside from making directional statements about the evolution of macro variables and types of return streams, the current crisis has implications for certain modes of investing, including environmental, social and governance (ESG).

Clients have asked us if current events might reduce the role of ESG in investment. We believe ESG is too deeply entrenched in the industry for that to happen—ESG not only survived the capital losses investors suffered at the onset of the pandemic, but in fact flows flourished during that period, strengthening its case. However, we think current events pose a new challenge to ESG investing.

The awkward observation is that ESG investing has benefited by evolving during a period of benign inflation, and the return of a different inflation regime requires a different response. Commodities have been the most effective hedges for risk-off swings in recent weeks. Is this a problem for ESG investors? In our view, it’s only a challenge to approaches that screen out certain categories of assets or exposures.

We think this development will likely enhance the case for ESG to revolve more around engaging with underlying issuers. We also think the current environment will accelerate the expansion of other types of ESG-related return streams, which we’ll address in future research. We’ve already pointed out that the “S” in “ESG” is likely to see more focus from the perspective of labor bargaining power; the current crisis could also renew focus on which kinds of regimes investors are comfortable investing in.

Market Sentiment: What’s Priced into Risk Assets?

A core question in allocating to risk assets is: What scenarios are priced in? In Europe, the spot equity risk premium (ERP) is at 9.2% (Display 1), in line with its position during the COVID-19 peak and the level reached in the wake of the sovereign debt crisis. The smoothed ERP is also approaching its 20-year highs. On this basis, the European market seems to already be pricing in a significant recession, though arguably not outright stagflation.

Display 1: Europe Equity Risk Premium Seems to Be Pricing in Recession

Historical analysis and current forecasts do not guarantee future results.
The equity risk premium (ERP) is defined as the MSCI Europe smoothed 10-year average trailing nominal earnings yield minus the market-cap-weighted index of European nominal 10-year government bond yields adjusted by the UK and German 10-year breakeven inflation rate. Spot ERP uses 12-month trailing earnings yield.
As of March 11, 2022
Source: Bloomberg, FactSet, Thomson Reuters Datastream and AllianceBernstein (AB) 

The US ERP is more subdued, with a spot reading of 5.2%, only slightly above its average since 2010 (Display 2). This seems fair enough, to the extent that the US is more shielded from these events,1 but it again suggests that the market isn’t pricing in a “worst case” in any sense.

Display 2: US Equity Risk Premium More Subdued than in Europe

Historical analysis and current forecasts do not guarantee future results.
ERP is defined as the US equity nominal earnings yield minus the US 10-year nominal bond yield adjusted by the 10-year inflation breakeven rate.
As of March 11, 2022
Source: FactSet, Thomson Reuters Datastream and AllianceBernstein (AB)

When using ERP, the question of the appropriate equilibrium level always arises; one can set it in relation to exogenous risk measures. Energy prices aren’t always relevant, but today they offer a clear metric for risk levels. Overlaying the US ERP (using cyclically adjusted earnings and US CPI index to adjust bond yields from nominal to real) indicates that the ERP is now high in this context, given the very recent decline in oil prices (Display 3).  

Display 3: US Equity Risk Premium Is High vs. Exogenous Risk Measure

Historical analysis and current forecasts do not guarantee future results.
ERP is defined as US 10-year average trailing nominal earnings yield minus US 10-year nominal bond yield adjusted by US CPI.
BBL: billion barrels of petroleum liquids
As of March 16, 2022
Source: FactSet, Thomson Reuters Datastream and AllianceBernstein (AB)

Measuring sentiment is the other angle for gauging what markets might be pricing in. One way we’ve done this for many years is by tracking investor flow data. Some weeks have seen the heaviest European equity selling ever. However, over the span of the war to date, outflows haven’t matched those in previous severe risk-off occasions, so it would be hard to claim a capitulation.

For making short-term (such as monthly) timing calls on global equities, we use a composite sentiment indicator that brings together flow, survey and positioning data. This metric is depressed today (Display 4), but not extreme enough to give a definitive contrarian indication.

Display 4: Composite Sentiment Indicator Is Depressed but Not Extreme

Historical analysis and current forecasts do not guarantee future results.
The composite sentiment indicator is a weekly series showing the equal weighted average of 52-week z-scores of the VIX and realized volatility spread, put/call ratio (based on the total volume of puts and calls on CBOE), CFTC Nasdaq speculative positioning, II survey Bull/Bear ratio and equity fund flow data from EPFR. The measure is a contrarian indicator—overly bullish sentiment would trigger a sell recommendation, and a buy signal when it is excessively bearish. The signal has greatest efficacy over short time horizons of about four to six weeks.
As of March 16, 2022
Source: Bloomberg, CBOE, CFTC  and AllianceBernstein (AB)

If we extend the horizon further, things are more encouraging for equities. The appetite for buying overseas stocks has declined to a point that there’s no net inflow right now (Display 5). In the past, such a lack of risk appetite has signaled overly pessimistic sentiment, which has been followed by positive returns on global stocks 12 months forward on the vast majority of occasions. 

Display 5: Subdued Cross-Border Equity Flows Could Support Future Returns

Historical analysis and current forecasts do not guarantee future results. 
Display shows the combined net purchases of overseas equities for the US, UK, euro area (post 1997), Germany (1987–1997), France (1993–1997) and Japan (post 1997). Data derived from external sector portfolio investment data published in the financial accounts of central banks. The series is monthly flows smoothed over three months, annualized and normalized by the market cap of the Datastream Global Equity Index.
Latest crossborder flow datapoint is based on three month non-domicile flow data into the US, Europe and Japan. Up to January 31, 2022.
As of January 31, 2022
Source: Banque de France, Deutsche Bundesbank, European Central Bank, Japanese MOF, Thomson Reuters Datastream, UK ONS, US Federal Reserve and AllianceBernstein (AB)

The bottom line from this sentiment and ERP analysis: it would be hard to claim that equities have priced in a “worst case” on a tactical basis. We’d also add the mysterious lack of sell-side analyst downgrades to this mix—presumably these are still to come. However, extending the time horizon out to a year or more makes longer-term sentiment measures more encouraging for putting a floor under risk assets.

1 See our review of Peter Zeihan, “The Accidental Superpower: The Next Generation of American Preeminence and the Coming Global Disorder,” 2014, in Inflation and the Shape of Portfolios.

Inflation: A Higher Peak, and Later than Initially Expected

The impact of inflation is probably the core frame of reference for investors right now. The world was already dealing with an outlook of higher inflation than the pre-pandemic level; now, the exogenous shock of war in Europe has introduced another form of inflation. Before the conflict, we viewed 2022 as a transition year from high inflation induced by the pandemic supply/demand mismatch to lower, but still elevated, inflation.

That narrative is out the window given current events: the inflation peak will be higher and arrive later than we previously thought.

The 1970s are a useful model, with high inflation brought about by a supply shock to commodities. We don’t see the current episode as a short-term disruption. We’re waiting to see whether the current situation escalates to shutting off the Russian energy supply or merely the need to endure a reduced supply. Either way, the economic and diplomatic language implies that the adjustment in energy supply will last, morphing with the transition to alternative energy sources in coming years.

As a result, we think consumers and industries will need to prepare for higher input costs. Once alternative energy investment is in place, that pressure could eventually abate. Current events are likely to lead to a faster onset of a less-globalized world, which will likely have a lasting direct effect on inflation in the years ahead.

Investors can’t ignore that this extra source of inflation comes at a time of renewed wage inflation, which is often stickier. The current debate is focused on the declining labor participation rate and labor shortages in some industries, which are driving wages up. But there are longer-term inflation pressures too: a shrinking global labor force, the deglobalization of labor and the ESG-related pressure to rebalance labor’s bargaining power versus capital. Consumers are well aware of sharply higher energy and food prices, which could leach into higher wage demands.

None of this makes us too concerned about runaway longer-term inflation, because deflationary forces are at work too, which we’ve outlined in our previous inflation research. But the situation does indicate a higher inflationary path than the one previously assumed.

This landscape limits central banks’ room to maneuver. The shift in market forecasts for 5- and 10-year inflation will weigh on policymakers’ decisions, which we’ve already seen in recent announcements by the European Central Bank (ECB). The US Federal Reserve was already on a tightening path. A 10-year breakeven inflation rate that’s nearly 100 basis points above the Fed’s target is sobering, and presumably warrants some policy tightening, but there may be limits compared with previous episodes. We’ve already seen language of “averaging” inflation over a somewhat unspecified window.

There’s also the role of fiscal policy in conjunction with monetary policy. We suspect that fiscal policy may be the more potent force in the wake of the pandemic experience, and that this episode will reawaken debates about public debt. Already back to levels not seen since 1945, the debt burden could grow further based on current developments. In that context, we suspect that somewhat higher (though not unanchored) inflation could be a highly useful tool to constrain debt levels—admittedly a very fine line for policymakers to walk.

What’s the Likely Impact on Economic Growth?

The risk of outright stagflation is materially higher than it was a few weeks ago. While the situation is extremely uncertain and changing daily, we can set parameters for thinking about its impact on economic growth. A common rule of thumb for the impact of oil prices on gross domestic product (GDP) is for a 10% increase in oil prices to reduce real GDP growth by around 0.3% in the US.2 Because Europe is more dependent on oil imports, we can assume a 0.4% impact in that region.

If oil prices were in the region of US$110 a barrel (the average level over the period since the war started) until the end of the year, the rule of thumb would imply a 1.4% reduction in US GDP growth. The International Monetary Fund (IMF) forecasts 4% real GDP growth for the US in 2022, so the growth rate for this year would fall to 2.6%. If we assume the same impact for 2023, the equivalent US growth forecast would fall from 2.6% to 1.2%.

In Europe, the situation is more challenging. The IMF forecasts GDP growth of 3.9% for 2022, so the estimated GDP reduction would be 1.9%, bringing Europe’s GDP down to 2%. For 2023, Europe’s growth would decline from 2.5% to 0.6%, assuming the same impact from oil prices. However, there are multiple paths to a more challenging situation than this one.

In the adverse scenario of a full Western ban on Russian oil, it’s not inconceivable that oil could hit $200 per barrel.3 In that case, the hit to US GDP would be more than 4.6%, and could well tip the economy into recession this year. In Europe, such a scenario would be even more damaging, reducing growth by over 6%, producing a severe recession.

Because Russian gas accounts for 40% of European consumption, another crucial consideration is the growth impact if sanctions were extended to gas imports—or if Russia were to decide to cut off or severely restrict Europe’s gas supply in retaliation for Western sanctions. There’s a focus on finding a quick path to reduce dependency on Russian gas, but it’s unlikely to be comprehensive.

According to analysis by Bruegel,4 a scenario where all Russian gas is cut off would require a minimum 10%–15% reduction in annual gas demand. Recent analysis by the ECB shows that the direct and indirect impacts of a 10% gas-rationing shock on the corporate sector could reduce GDP by 0.7%.5 If we assume that the European industry bears all this demand reduction, it would be a GDP drag of 0.7%–1%. So, in a scenario where oil prices stay around the levels we outlined earlier, the gas impact would further reduce forecast European growth to 1.3% or 1% for 2022. The same impact for 2023 would be enough to drag Europe into a recession.

The very recent prospect of talks has brought energy prices down, but the difficulty of reading the near-term path and the sensitivity this has created to sources of energy mean that this topic will remain key to investors.

This analysis is very rough but shows that it’s not hard to envision scenarios that could lead Europe and the US into stagflation. Europe, in particular, looks very vulnerable over the next two years if we assume energy prices stay near current levels.

However, we would expect a fiscal response from Western governments, and the fact that this would happen after the pandemic is crucial, in our view.

We pointed out in our recent black book, Are We Human or Are We Dancer?, that the post-pandemic period brings a new environment. The COVID-19 experience showed great willingness from the US and European governments to use all fiscal tools at their disposal in response to a crisis. We already see proposals within the European Union (EU) for a large joint bond issuance to finance energy and defense spending. If passed, this measure could fund infrastructure to wean Europe off Russian energy and could also be used directly to cushion the impact of higher energy prices.

We don’t know yet what the contours of such a fiscal response would look like, but we think its occurrence while the memory of government support during the pandemic is fresh would be instructive. Ultimately, we think that governments have a freer fiscal hand in the post-COVID-19 world, and that public debt levels can rise.

2 See, for example, Nouriel Roubini and Brad Setser, “The effects of the recent oil price shock on the U.S. and global economy,” August 2004. Available at: https://pages.stern.nyu.edu/~nroubini/papers/OilShockRoubiniSetser.pdf.

3 “The West’s threat of a ban on Russian oil shakes markets,” The Economist, March 7, 2022, https://www.economist.com/finance-and-economics/the-wests-threat-of-a-ban-on-russian-oil-shakes-markets/21808059.

4 Ben McWilliams, Giovanni Sgaravatti, Simone Tagliapietra and George Zachmann, “Preparing for the first winter without Russian gas,” Bruegel Blog, February 28, 2022, https://www.bruegel.org/2022/02/preparing-for-the-first-winter-without-russian-gas/.

5 Vanessa Gunnella, Valerie Jarvis, Richard Morris and Máté Tóth, “Natural gas dependence and risks to euro area activity,” ECB Economic Bulletin, January 2022, https://www.ecb.europa.eu/pub/economic-bulletin/focus/2022/html/ecb.ebbox202201_04~63d8786255.en.html.

What Approaches Work in an Environment of Stagflation?

Global growth is less energy intensive now than in the 1970s, but that period is still an instructive starting point for thinking about the impact on assets. In our previous work on how to protect portfolios against inflation (Assessing the Inflation Trajectory—and Portfolio Responses), we distinguished periods of moderate inflation from periods of high inflation, and also between what constitutes a short-term inflation hedge versus longer-term considerations, which are more likely to focus on a sustained ability to generate positive real returns rather than having a high beta to inflation, per se (Display 6).

In the current crisis, investors’ attention is focused on the risk to portfolios of excessively high inflation. Yes, the long-term implications of the current crisis include a prolonged energy-supply disruption and accelerated deglobalization, but we expect the current level of inflation to moderate, not persist. Starting from a strategic asset allocation perspective, and considering portfolio positioning for the next five years, we’d still consider “moderate” inflation the most likely outlook, so the key portfolio anchors would be equity beta, real estate, equity factors such as income and value, and a range of physical real assets.

Display 6: Real-Growth and Inflation-Hedging Tool Sets Evolve

Historical analysis and current forecasts do not guarantee future results.
EM: emerging markets
Source: AllianceBernstein (AB)

But the risk of stagflation challenges this approach over the nearer term. For Europe, especially, stagflation risk is high. Expensive energy has already raised input prices to a level that will hurt growth, there’s the risk of a curtailment of energy supply, and the ECB has outlined a hawkish line on inflation. The prospect of fiscal support (unlike that in pre-COVID-19 recessions) can help, but the risk remains.

The situation is less strained in the US, but the inflation peak will be higher than previously thought, and occur later, while higher input prices will hurt growth. The Fed has outlined a path of action already, but its room to maneuver has been constrained.

Given this backdrop, the clamor to consider stagflation hedges for portfolios is understandable.

There are a few possible definitions of stagflation. The historical experience is heavily influenced by the 1970s, but the specific performance of individual assets depends on whether one is seeking to insure portfolios only over the specific stagflation period, or over a longer period. To overcome that challenge, we’ve used three possible scenarios (Display 7):

1.       Historical inflationary shocks that coincided with a sharp slowdown in real economic growth. Date ranges include 1Q 1970–4Q 1970, 1Q 1974–3Q 1975, 4Q 1979–4Q 1980 and 1Q 1982–4Q 1982.

2.       A narrower definition of inflationary shocks and low growth, looking only at periods where real GDP growth was less than 1% and inflation more than 4%. These include 1Q 1970–4Q 1970, 1Q 1974–3Q 1975, 2Q 1980–4Q 1980 and 1Q 1982–4Q 1982.

3.       A focus on scenario 1 episodes, but extending the time horizon to earlier quarters, when higher growth was starting to slow and inflation starting to rise. This scenario includes only quarters where falling real growth coincided with rising inflation, including 3Q 1973–4Q 1974 and 1Q 1979–1Q 1980.

The main difference with merely insuring against moderate inflation is that an outright position in equity beta is no longer the key portfolio anchor. At one end of the extreme, Treasury Inflation Protected Securities (TIPS) look attractive on this basis, but they’re the most expensive form of inflation protection right now. For anyone ultimately targeting a positive real return, the cost of TIPS reduces their role.

Commodities have been the most effective hedge in the recent crisis, and the longer-run history dating back to the 1970s backs that up. This situation creates a challenge for some ESG strategies, a point that we’ll revisit in future research. We think that, in time, the role of commodities in a portfolio (and indeed the economy) will be replaced in part by return streams from delivering renewable power. If one is fortunate to have access to that exposure in a portfolio, that’s great—but right now it’s small in scale. Real estate also has a role as an inflation hedge. It can lag in the short term if rent reviews lag rapid inflation moves, but it’s ultimately a claim on a cash-flow stream set in the real economy.

A set of factor strategies is also important in this context, including free-cash-flow (FCF) yield in equities and FX carry in bond markets. This is slightly different from the experience of the value factor, which tends to respond well when inflation rises moderately. The FCF yield factor in equity can be thought of as an income factor that can continue to deliver positive real income even when inflation is elevated. The level of FCF dividend cover is a critical metric for determining the ability to maintain or even grow dividends, so this factor becomes attractive for the ability of its constituents to continue payments. Positive returns from fixed-income carry strategies follow a similar logic, given their income stream.

Momentum or trend strategies can be interesting too: they benefit from a sustained price move but suffer if prices don’t move or sharply reverse. These factors have shown the ability to protect portfolios over periods of rising prices, and they might also be an important diversification source.

Farmland is not shown in the table because there’s no comparable data frequency—real returns from US farmland remained positive throughout the high inflation and stagflation of the 1970s. This asset was already appealing given the intersection of a possible overlap between inflation hedges and ESG, and the impact of the current crisis on food prices makes it even more so. 

Display 7

Historical analysis and current forecasts do not guarantee future results.
Scenario 1: Historical inflationary shocks that coincided with a sharp slowdown in real economic growth, with date ranges including 1Q 1970–4Q 1970, 1Q1974–3Q 1975, 4Q 1979–4Q 1980 and 1Q 1982–4Q 1982
Scenario 2: A narrower definition of inflationary shocks and low growth looking only at periods where real GDP growth was less than 1% and inflation was more than 4%. Those include: 1Q 1970–4Q 1970, 1Q 1974–3Q 1975, 2Q 1980–4Q 1980 and 1Q 1982–4Q 1982
Scenario 3: Based on the changes in growth and inflation, this scenario focuses on the scenario one episodes but extends the time horizon to earlier quarters, when higher growth was beginning to slow and inflation starting to rise. This scenario includes only quarters where declining real growth coincided with rising inflation, including 3Q 1973–4Q 1974 and 1Q 1979–1Q 1980
Source: AQR, Global Financial Data, Kenneth R. French Data Library, Robert Shiller’s database, Thomson Reuters Datastream and AllianceBernstein (AB)

Where Does This Leave Portfolio Positioning?

For investors seeking a tactical position, we think it’s too soon to say we’ve definitively reached a bottom. Talks between opposing forces in the Ukraine war offer some hope, and discussions about a fiscal response and possible output boosts from other oil producers might provide support for risk assets.

But this isn’t enough on which to base a tactical case. If we focus on indicators from within the market, elevated risk premia and significant equity outflows would make it hard to claim that markets are pricing in a worst-case scenario while the possibility of further escalation remains. Our more systematic sentiment indicators show that sentiment is understandably at a low ebb, but not at a level that, by itself, would signal an unambiguous “buy.”

Longer term (a horizon over one year), the prospects are more hopeful. Fiscal support could alleviate the worst of energy-price inflation, and over a medium-term horizon we expect inflation to fall back to a level that’s higher than pre-pandemic levels but not beyond the tipping point that makes it negative for equities. The abrupt run-up in the US 10-year breakeven to 2.9% has been one of the most significant shifts in inflation signals in recent weeks. However, it’s still consistent with a positive real equity return.

Even in Europe, where the impact of the current crisis is most acute, there are offsetting positive longer-term forces: greater acceptance of EU bond issuance, the closer integration of some of the more “wayward” eastern EU members with the bloc, and the startling pace of change in German foreign and energy policy. All these matter for long-term growth.

The current crisis raises new questions for ESG investing—both within asset classes and in a multi-asset sense. We absolutely believe that ESG investing will survive this challenge, but some definition of ESG will need to adapt. If stagflation risk rises, so will the importance of commodities in the toolkit of responses. For example, if an ESG approach prohibits any commodity or commodity-linked assets, particularly with reference to oil, it will be challenging to appropriately hedge against near-term risks.

Of course, ESG approaches don’t have to take this line; an approach based on engaging with underlying assets rather than drawing hard lines around certain types of assets can adapt much more easily. Ultimately, we think this state of affairs will hasten the development of more return streams that lie at the intersection of ESG and inflation—the subject of our next note.

The bottom line is that investors must redouble the urgency of protecting their portfolios against inflation. For those with a longer time horizon, we think this can be achieved via equity beta, cross-asset factor strategies, commodities, physical real assets and private assets, such as private debt.

For those with shorter time horizons, it’s hard for equity beta to anchor such an approach, implying that factors, physical real assets and some private assets are more attractive. We recently wrote about the migration to illiquid assets, which may have gone too far, in Private Assets and the Future of Asset Allocation. In the medium term, equities should be part of the inflation protection response, but in the very short term we can’t say that a floor has been reached. 

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