Cautious positioning required as Ukraine escalation adds to stagflationary risks

The overnight escalation of the Russia-Ukraine crisis is a worrying development with serious macro and market implications.

Our asset allocation view has been turning cautious since Q4 2021 and is likely to remain so given the spectre of war in Europe.

Two of the most significant risks are the conflict spilling into the Baltic states, which would draw a reaction from NATO, and wide-scale disruptions to the European energy supply, as 40 per cent of European gas comes from Russia. 

As we highlighted in a recent piece, the energy markets are the key global macro channel and any escalation will further add to stagflationary risks. The challenges facing monetary policymakers, especially at the European Central Bank, have become significantly more complicated as another supply side shock hits the system. 

Markets must now assess how the latest developments affect the possibility of a Europe-wide war as well as the medium-term macro implications. The West’s response will be key, as the sanctions unveiled up to now have been lukewarm at best.  

The team’s tactical trades are tilting towards Asia, with relative positioning overweight China and overweight ASEAN regions. These regions have valuation buffers given previous corrections, supportive policy, and economics, and are relatively well insulated from the geopolitical situation.

The outlook over the next 12 months could yet become more positive. We are still mid-cycle, and there is the possibility that inflation will moderate, allowing central banks to be more dovish. However near-term risks have risen very sharply, and much will depend on how the Russia-Ukraine situation develops. Managing risk carefully in these coming months will be key, with a focus on downside protection and careful monitoring as this dynamic and complicated situation evolves. 

We remain underweight risk assets for now to reflect the increasing stagflationary and geopolitical risks but will watch the developing situation carefully, and look to step back into risk if we see the right time and opportunity to do so longer-term.