The impact of the pandemic and war in Ukraine

Is the world prepared for what lies ahead?

11 March 2022

Our Chief Investment Officer talks about the economic and market impacts of recent events and on-going war in Ukraine.

The current landscape

While the events in Ukraine are extremely tragic, it would be remiss of us not to comment on the economic ramifications of the conflict. Looking at history, we know that both inflation and interest rates tend to rise during times of war. In Europe, we are already seeing evidence of increased defence spending, particularly in Germany where there has been a notable change in policy. We continue to see a broad-based surge in commodity prices in response to the ongoing escalations.

The world economy entered this crisis in relatively good and improving health, as evidenced by the latest US employment report and the latest batch of business confidence surveys. However, the steep rise in commodity prices in particular and the potential tightening of financial conditions as a result is seeing investors becoming more risk averse.

Our current baseline is that the conflict is an absorbable stagflationary hit for the global economy. What has been surprising are the unexpected policy outcomes. Europe has taken a significant step forward in its integration process with talk of funding defence spending out of a common bond issuance, which has boosted equity markets and bond yields.

In terms of portfolio positioning, we added a sizeable position in diversified commodities at the start of 2021, which has proved to be a good diversifier. We went into this crisis with an underweight position in junk credit, which has since played out and we have now closed the position at a profit. Generally speaking, we're pleased with how portfolios are holding up amongst all of this volatility.

As always, we recommend investors get invested, stay invested, and stay diversified.

PHIL ATTREED: Hello and welcome to the March episode of Monthly Market Insights. I’m Phil Attreed, Barclays’ Head of Wealth Specialists, and once again I’m joined by Will Hobbs, our Chief Investment Officer.

Now as is clearly apparent to all of our listeners, the past month has brought yet more human suffering and tragedy heaped on a world that frankly has probably had its fill of challenges the last couple of years.

Of course, our first thoughts do go out to all of the victims of the war in Ukraine. However, of course, this recording seeks to attempt to update and inform you, our listeners, about the economic and market impacts of the outcomes and the headlines of the events that are ensuing.

Will, to start, we often tease you on a number of these calls and podcasts about the history lessons that you give us, but it's probably quite apt at the moment that we understand from you if there are indeed any lessons from history with regards to the economic impacts and effects of war.

WILL HOBBS: Yes, Phil. I second it, obviously. At the moment, times like this, again, it feels like focusing on the economy and the markets feels like missing the point by some distance. But like you say, we have a job to do.

Now, from the perspective of the economy you can approach it a couple of ways. So like you suggested: first you can look at the history, the message from history, if there is any. It won't surprise you to know that there's been a whole load of work over the years, academic and otherwise, on the interaction of war and the economy.

In fact, there are a large cohort of economic historians who argue that one of the primary reasons for Europe’s surge to the economic top table earlier than almost anyone else in the 18th and 19th centuries was because it had been almost perpetually at war since the fall of the Roman Empire, and that had equipped them better for colonial land grabs and all the economic benefits that came with that, but also welfare states and how to adapt to industrialism.

But more recently there's been a paper which quite interestingly focused, or a couple of papers that interestingly focused, on the economic aftermath of pandemics versus wars. And there's one in particular I’m thinking of, looked at comparing 12 of the biggest wars and 12 of the biggest pandemics since the 14th century and, like I say now a disclaimer, you've obviously got to be incredibly careful of how you interpret this data. Twelve is a very small sample size – the differences are sometimes more instructive than the similarities and so on and so on. However, broadly speaking, I think the message is relatively intuitive in terms of what you can think about.

Whereas pandemics are seen to deflate all things being equal – they drive aggregate demand, inflation, and therefore interest rates they tend to lower as we've talked about you and I a lot, wars do the opposite – inflation tends to rise, as do interest rates. Wars tend to result in increased defence spend – as we are already seeing in Europe and Germany, the astonishing change in policy there – but also widespread, tragically, destruction of physical capital which tends to need to be replenished.

So that's the broad message from history is that you probably get on average, and there can be a huge dispersion of outcomes beyond that you get more inflation and higher interest rates.

PA: And so turning to this situation more specifically, what are some of the things that we should be thinking about when it comes to the impact maybe on the wider economy?

WH: I think here particularly, you can think of a number of extra things – one, you can think about the potential for decoupling of global supply chains between east and west potentially, the fragmentation of the global commodity market, which you're already seeing, as further inflationary forces to keep an eye on.

From the perspective of what Ukraine and Russia specifically are important to in terms of supply chain or in terms of producers (oil, gas is the obvious one, but also cereals, Ukraine is very important in this area), and you are seeing, as you know, broad-based surge in commodity prices in response to the ongoing escalations.

Now, in the short term, just looking at what we can expect from incoming economic data in the next few months, the world economy entered this crisis in relatively good and improving health. You saw that from the latest US employment report, the latest batch of business confidence surveys, all suggest that the world economy was looking okay and improving going into this thing.

Now the blow from commodity prices in particular and potentially tightening financial conditions as a result, as people feel more risk averse, that will obviously affect different parts of the world differently. Of the developed economies it's obviously primarily Europe that suffers the greatest stagflationary hit, more inflation, a bit less growth.

There's a huge reliance on Russia, which is Russian gas, which is a big part of that obviously that's been spoken about a lot. Most European banks don't have much in the way of direct exposure to Russian loans but you can keep an eye out for some of the Austrian banks which have a little bit more proportionally.

America on the other hand is much more insulated in reality. Petrol prices, as in prices at the pump, they are a huge political issue but our overall sense is that as at the moment the hit that is coming to the US economy is likely absorbable. The growth momentum going into the crisis is key I think; however, also important obviously – and this is something that everyone has pointed out – is that how long the crisis goes on for, is there the degree of war contagion, so to speak, of other countries sucked in directly.

Now, our current baseline is that it's an unhelpful but absorbable – an unwelcome but absorbable – stagflationary hit for the global economy. but we're obviously following closely. The other thing just to keep an eye on, and we've just seen this on the news today (8 March 2022) and seeing it hit the wires now, is the potential for unexpected policy outcomes.

So one of the things that characterised the aftermath of the first hit of the pandemic, COVID-19, was policy response that people weren't quite expecting, the so-called 'Alexander Hamilton' moment one for Europe. You're seeing the second Alexander Hamilton moment, or at least the potential for one – that's the moment when Europe suddenly gets its act together and moves a huge step forward in its integration process and you've seen that potential today be raised and start to boost equity markets and bond yields as a result, as the talk of funding defence spend out of common bond issuance which is something that people have looked for from Europe for a long time.

So again, policy can go both ways in a way and it's something else to watch with regards to the crisis.

PA: Quite, and maybe if we turn to investments next. We've seen some fairly sharp falls and with it some pretty significant volatility as well, ups and downs even intraday, you referenced it there, we've seen a bit of a switch around today but also some falls in other perceived riskier assets.

But on the flip side actually, you've referenced it earlier on, some of the commodity prices we've equally seen that you've referred to being helpful towards multi-asset class portfolios that hold them. So what are your general thoughts on investment assets overall in recent weeks?

WH: Yes, Phil, good question. I think you're right on the commodities. That has provided welcome insulation as you know, we talked about a lot. We added a big chunk of diversified commodities to portfolios at the beginning of last year, 2021, which was very helpful last year and so far this year they've been a good diversifier.

More broadly the work for shorter-term investors, now tactical investors – and as we have a specialist team that looks at this and trying to add those performance cherries to the overall cake of returns that we hope to offer our clients on a regular basis – it's really about trying to establish how much of the various risks inherent in this situation, in this awful situation, are already incorporated into prices.

As we saw with the pandemic, most of the assets in our portfolio, most of the assets that you have access to in capital market (stocks, bonds, all that stuff) they're anticipatory in terms of, the prices don't just wait for stuff to happen, our investors don't just wait for stuff to happen, investors are always updating a probabilistic assessment of the range of potential outcomes from this point. And there are a couple of ways of doing this process of trying to establish what's already in there.

So as you know there's the VIX index, which is popularly known as the 'fear gauge'. It's a measure of the stock market's expectation of volatility on the S&P500, the US stock market based on S&P index options. And that has already risen to levels consistent with the worst geopolitical crises of the post-1990s period. So that does give you some sense that some of the potential worse outcomes of this crisis are already incorporated – that's not to say all of them by any stretch, unfortunately.

Another is thinking about something called the 'equity risk premium' and that's the extra return and investor demands over and above bonds for the risk of owning companies. So it's that extra volatility and risk that you get with stocks and what do people want in excess of that. And that waxes and wanes according to various factors; it's not observable directly so it's quite difficult. But again what you've tended to find is that since the beginning of the crisis the equity risk, the rise in the equity risk premium, the rise in that excess expected return by our measures, is consistent again with what you saw in the aftermath for US equities of 9/11.

It's about double in European equities what we saw in terms of rise in equity risk premium after the Crimean annexation. So there's a bit in prices. For commodities, it's a bit different because remember the point here is that, it's often made, this isn't an anticipatory asset it's a spot asset.

So basically, you can't kick the can down the road with commodities, you have to find the supply today and prices have to incentivise that supply. So somehow you've got to get suppliers sufficient compensation for the risks that they perceive. And so that is something a bit different in commodities at the moment and we just don't know where that level is. You're seeing it with oil and gas, you're seeing surges forward and we're glad to hold some in portfolios at the moment, but we are also aware that those same commodity prices are going to create some problems for households and others down the road. So that's something to keep an eye on.

PA: Quite. And that leads me nicely onto the final question: are you and the investment teams maybe making or considering any changes to investment portfolios and funds that we're managing for clients at the moment?

WH: I think we've said this before, I mean, not too much at the moment. One of the things that we have done recently was that we went into this crisis with an underweight position in junk credit, so low-rated credit. That played out in our opinion, so we were happy to close that position and bring that back to neutral at a profit. So that was a that was a good trade from the team.

And otherwise it's really just watching, and really at the moment we're pleased with how the portfolios are holding up and amongst all of this volatility. And actually the value of diversification again, not just commodities but investing across styles, as you know. We keep an equity foot in some of the dustier corners of the equity market deliberately and that has been also very helpful in performance so far this year in these very uncertain times.

And like we said before, you and I, this in a sense would increase the risk or the probability that what you're seeing in the years ahead is quite unlike – from a macroeconomic, geopolitical, regulatory, all of those perspectives – what we've got in our road ahead it looks quite unlike potentially the one in the rear view mirror. So that means you've got to think quite differently about the kind of assets that you want to deploy in order to maximise your chances of beating inflation and maximising your chances with the power of your savings. Beware past performance, that's the message really, as always. The regulator's right.

PA: So, happy pretty much to stay fairly neutrally positioned then for the time being?

WH: For the time being.

PA: Good. Thanks as always, Will, good insights as we navigate this challenging period. Thank you also to our viewers and listeners for joining us and if you would like to hear more from us before the next Monthly Market Insights, please do seek out our weekly podcast Word on the Street where we share all of our latest views on the developments.

The impact of the pandemic and war in Ukraine

As part of our aim to keep clients and customers informed of our current investment views and how these themes are impacting our portfolios and funds, Phil Attreed, Head of Wealth Specialists, talks with Will Hobbs, Chief Investment Officer, about the economic and market impacts of recent events and on-going war in Ukraine.

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