Russia’s war on Ukraine has shaken the world. From a massive humanitarian crisis to an energy shock to food insecurity, the ripple effects are already being felt near and far. Even if the conflict ends tomorrow, the invasion could have lasting global consequences. Amid heightened geopolitical tensions, continued volatility over the near term is the only certainty. Below are the top risks—and strategies—we think bond investors should keep in mind.
Worsening Inflation
The conflict will inevitably drive food prices higher. Together, Russia and Ukraine comprise more than a quarter of global wheat exports, and Russia accounts for 13% of global nitrogenous fertilizer exports. The biggest impact will be felt by emerging-market countries that rely heavily on imports from Russia and Ukraine, including Egypt, Indonesia, Brazil and Turkey.
Technology will also become more expensive. A single Odessa-based company supplies 65% of the world’s neon gas, used in the production of computer chips. That will likely hurt developed markets most.
But the energy shock will surely have the biggest impact everywhere. Russia is the world’s third-largest oil producer and the world’s largest exporter of oil, according to the International Energy Agency. Russia alone supplies around 40% of Europe’s energy needs. In the near term, rising energy prices are stagflationary: boosting prices in the near term but hurting growth down the road as high prices force consumers to curtail their spending.
Central Bank Responses Diverge
These inflationary catalysts have put central banks in a different position than six weeks ago. Inflation pressures were already high coming into the Russia-Ukraine crisis, and many emerging-market countries were well into tightening cycles. Today, the right response from central banks depends on the underlying balance between growth and inflation, which differs by region.
The US Federal Reserve hiked 25 basis points in mid-March—its first rate increase since 2018—and signaled that it isn’t afraid to be aggressive. We think it’s likely to keep raising rates at every meeting well into the second half of the year and will start paring its balance sheet soon. The Fed will wait to see if the war necessitates a change to its economic outlook and policies.
Meanwhile, the European Central Bank (ECB) announced an acceleration of its tapering program. It characterized the decision as taking a middle ground between two extremes: 1) doing nothing and waiting to see how the crisis in Ukraine plays out, or 2) reacting more aggressively to the run-up in inflation that’s about to get worse. Inflation is the crux of the ECB’s mandate, and the central bank wants to have all options open as the year progresses.
In our view, this risks worsening an economic situation that’s already deteriorating rapidly. The market response to the ECB’s hawkish surprise? Rising rates, wider peripheral spreads and falling equities. These developments represent a tightening of financial conditions that we believe is inappropriate for the current economic situation. We’ll wait and watch for improvement in the geopolitical situation before becoming more optimistic about the euro area’s economic outlook.
Among emerging markets, some central banks are in a particularly difficult position. Across Latin America and Eastern Europe, inflation pressures have been more acute, and policymakers have already increased interest rates. As food and fuel prices continue to rise, emerging-market countries could be vulnerable to economic scarring, social unrest and delayed fiscal consolidation.
China Faces Challenges
Eyes are also on China, which faces challenges on three fronts—its relationship with Russia, now cast in the new light of Russia’s invasion of Ukraine; idiosyncratic news affecting China’s property sector; and a spike in coronavirus infections.
Of these, COVID-19 is biggest the risk to our GDP growth forecast in 2022. We expect the current outbreak to weigh on economic activity in March and the first quarter. What the path looks like after that depends on how quickly Beijing controls the outbreak and how much additional policy support it delivers to counteract the hit to growth.
For now, we have maintained our growth forecast of 5.3% for 2022. In our analysis, the odds are low that China’s government will allow growth to fall below 5%, as it still has a growth target of around 5.5% for the year and many policy tools available to make it happen. Given the uncertainties around the outbreak, however, we will continue to closely monitor the situation.
Investing Spotlight: High-Yield Corporate Bonds
A slower growth outlook, tighter monetary regimes and flat yield curves are typically headwinds for growth assets like high-yield credit. But there are several reasons we think developed-market high yield looks quite attractive today.
First, high-yield corporates entered the current landscape with strong long-term fundamentals. Developed-market high yield went through a default cycle just two years ago when the pandemic hit. The companies left standing are in the best shape they’ve ever been. Notably, these companies aren’t heavily reliant on energy, so while high energy prices affect them, they’re not likely to cause credit deterioration. Meanwhile, consumer and corporate balance sheets remain strong, giving corporate issuers a big cushion for an economic slowdown. As a result, we expect defaults to remain very low by historical measures over the next 12 months.
Second, at today’s wider credit spreads, high yield is fairly valued. Because the market isn’t concerned about defaults, it isn’t demanding a premium for default risk. But the premium for volatility is historically elevated. In other words, when market volatility declines from today’s levels, so too will spreads; and conversely, if market volatility increases, spreads will likely widen. We expect that, given heightened geopolitical tensions, even if the conflict in Ukraine ends tomorrow, elevated volatility will likely persist for an extended period, keeping spreads wide. In this environment, “carry”—essentially, clipping the bond’s coupon—rules the day.
Third, today’s higher yields signal higher returns for high-yield bonds (and other high-income asset classes). History shows that the US high-yield sector’s yield to worst has been a reliable indicator of high-yield return over the following five years. In fact, US high-yield bonds have performed predictably, even through one of the most stressful periods of economic and market turmoil on record—the global financial crisis. During that period, the relationship between starting yield to worst and future five-year returns held steady. Why? High-yield bonds supply a consistent income stream that few other assets can match.
Strategies for Today’s Bumpy Ride
Here’s how active investors can rise to the challenge in this environment:
Lean into high-yield credit. Yields across most risk assets are higher today than they’ve been for some time—an opportunity investors have been waiting a long time for. Among the high-income sectors, including emerging-market debt and securitized assets, high-yield developed-market corporate credits look especially compelling today. With the yield to worst on the Bloomberg US Corporate High-Yield Bond Index averaging around 6% and long-term fundamentals still positive, investors with a longer-term lens can ride out short-term drawdowns.
Be dynamic. Active managers should prepare to be extra active to take advantage of quickly shifting valuations and fleeting windows of opportunity as other investors react to headlines.
Choose the right approach. Global multisector approaches to investing are well suited to a quickly evolving landscape, as investors can closely monitor conditions and valuations and prepare to shift the portfolio mix as conditions warrant. Among the most effective active strategies are those that pair government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio.
This approach can help managers get a handle on the interplay between rate and credit risks and make better decisions about which way to lean at a given moment. The ability to rebalance negatively correlated assets helps generate income and potential return while limiting the scope of drawdowns when risk assets sell off.
New World Order: Russian Invasion Has Lasting Implications
Amid the fog of war, it’s hard to focus clearly on how the conflict will change the world in which we live and invest. But it’s not too soon for investors to start framing the secular issues that will undoubtedly reshape the way we analyze countries and companies and build portfolios for years to come.
For example, how will Europe change? As European countries recalibrate their energy strategies, will there be an accelerated push for renewables? If Russia is locked out of European markets, will it try to redirect its oil and gas supplies toward China and other Asian countries? Will the war change the way ESG investors think about defense companies?
Down the road, commodity markets may look very different than today, with potentially large changes in sources of production, as well as in transportation and refining capacity. Deglobalization may gather steam. What happens if more economies bring production back to their home markets? These are just some of the complex issues our investment teams are beginning to explore.
For now, we encourage bond investors to keep their balance by fixing their eyes on the horizon. By taking a longer view, investors can avoid overreacting to today’s headlines—even as they shift tactically to trim sail as other investors overcorrect.