By Peter Zaltz
Russia’s invasion of Ukraine has alarmed the international community and raised concerns over the people in Ukraine caught in the middle. We share these concerns, and we also maintain our focus on stewarding our clients’ investments in a market that is adjusting to the rapidly-changing situation in Europe. We have reviewed our exposure to Russia at this time and feel confident in saying we currently have no material risk to the portfolios; we currently do not own any Russian companies or have material exposure to the Russian ruble. Russia is being isolated economically in an unprecedented fashion and we are watching how this may affect markets and the corporate sector.
For investors, the invasion has further roiled markets that were already subject to higher-than-normal volatility due to generationally-high inflationary pressures and the prospect of significant monetary tightening by central banks. Indeed, the Bank of Canada (BoC) has initiated its own tightening cycle with a 25-basis-point rate hike, and the U.S. Federal Reserve is expected to soon raise its key rates.
We have been laser-focused over the last several months on the recent and still-expected shifts in monetary policy and have positioned our strategies appropriately, with an eye to both managing risk and capitalizing on what we expect to be significant market opportunity that should materialize over the medium-term.
That said, the situation in Ukraine has created significant disruptions to the global economy and has prompted massive sanctions against Russia by Western governments. This has raised economic uncertainty, shifted the outlook for inflation and has forced us to reconsider some of our assumptions for the pace of rate hikes.
In the statement accompanying its rate hike, the BoC noted the conflict in Ukraine is pushing up prices of energy and food-related commodities and that it now expects inflation to be higher down the road than the bank had projected in January. This confirms what had been apparent on financial markets, as WTI crude has risen above US$100 a barrel for the first time since 2014, while Russia’s status as Europe’s key natural gas supplier has pushed gas prices sharply higher. Bond yields that had been rising in anticipation of extensive tightening have now retraced some of their gains as investors have sought lower-risk assets. Looking ahead, the concurrent predictions of persistently higher inflation and slowing growth raise the risk of a significant economic slowdown that central bankers had been hoping to avoid.
However, we have been pleased to note that funding markets have not seized up the way they did during the Great Financial Crisis in 2008. We have seen a continuation of new bond issues which means companies can continue to access funding, a sign of the effectiveness of measures put in place following the 2008 crisis.
We are certainly not in the business of predicting the outcomes of wars, but it is worth noting that the market impact of geopolitical conflict has historically been relatively short-lived. It is also difficult to find a recent situation comparable to the current one, and so we are remaining nimble in our approach. As markets had been in a state of higher volatility even before the runup to the invasion, we have entered this situation well positioned for market turmoil and we are optimistic about our position and the outlook for each of our public strategies.
On equity markets, the key Canadian and U.S. equity indices have each come down from their recent all-time highs. However, this decline has been primarily due to falling valuations, as opposed to weaker earnings. Indeed, 2022 consensus earnings estimates have moved higher so far this year as PE multiples have dropped, with the highest-multiple companies faring the worst.
Our approach in our U.S. Equity strategy has been to avoid the frothier parts of the market, including many of the growth names that have been hit particularly hard. In early January, we took an increasingly defensive stance by exiting some of our tech holdings and reducing our exposure in industrials and materials. Since then, the U.S. selloff has increased, and we have seen tech names we would consider high quality, such as Adobe, sell off to pre-COVID valuations.
Currently, our U.S. strategy is positioned in larger-cap, quality stocks with earnings stability and high cash return. We have been patient in our Global Situations strategy, with exposure of around 60%. Looking forward, we will continue to be cautious until we see attractive entry points.
In Canada, equities have outperformed the U.S. so far in 2022, due in part to valuations that were less stretched during the pandemic. TSX stocks have been trading as a group around 15x 2022 earnings, which is an attractive level. In our Premium Income strategy, we maintain a balanced mix of growth and value stocks with a focus on careful security selection. We have recently added exposure to consumer discretionary stocks, and we feel the strategy is well positioned to manage through the current disruption.
In our International strategy, we have a tilt to value in Europe, as well as in Japan, where we are overweight real estate as a hedge on inflation. The strategy is also overweight energy and basic materials, and we have been recently adding to high-quality growth stocks that have had sizeable corrections. European stock markets have understandably been under considerable pressure due to the conflict in Ukraine. But even before the invasion, relative valuations in Europe had been at their lowest levels in a decade, with stocks declining even as earnings strengthened. We are concerned about the possibility that higher energy prices resulting from the situation in Ukraine could impact European growth. However, looking beyond the conflict, we see the possibility of a substantial upwards move in European equities.
While equity markets have seen increased volatility, the picture has been considerably more volatile for credit markets, where the prospect of central bank tightening has resulted in higher yields and substantially wider credit spreads. This has been particularly challenging for long-only bond funds, although the flight-to-risk move since the invasion has prompted prices to recover somewhat.
We have not been immune to this disruption and have endured challenges in our investment grade and high-yield portfolios. However, the substantial spread widening we have already seen has resulted in a more positive picture moving forward and has presented more appealing income-generating opportunities than we have seen in quite some time.
With our Blair Franklin Global Credit Strategy, we have the benefit of our long/short approach, as our short positions have cushioned the impact of the general selling. We are remaining cautious because we are still at the beginning of the hiking cycle and are finding very appealing opportunities to add exposure. This should benefit the portfolio as markets adjust to the new reality of progressively higher interest rates. We are also encouraged by the robust performance and capital positions of banks and other financials, which are the areas we focus on most in the strategy.
Our High Yield strategy has also suffered from the market turmoil, but the widening of spreads has made for a much more appealing picture going forward. Our Senior Credit strategy has been a stronger relative performer due to the floating-rate nature of the asset class, which should allow it to benefit from higher rates.
Looking ahead, we will rely on our disciplined, bottom-up approach as the market reacts to the situation in Ukraine and the coming interest rate hikes. Despite tighter monetary policy, it is likely inflationary pressures will continue to get worse due to the Ukraine crisis, as well as to the fact that there is a considerable time lag between interest rate hikes and their cooling effect on inflation. We are concerned about the potential for an escalation of the situation in Ukraine, but also heartened by the powerful reaction of the international community, including Germany’s decision to shift its foreign policy to potentially take a more active role. We will continue to watch the situation closely. We also believe that volatility brings with it opportunities, and we will continue to search those out.
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