What can investors do?
Periods of episodic extreme uncertainty are not times to make knee-jerk reactions. Markets can move non-linearly, in unexpected directions, aggressively and rapidly. Instead, now is the time to rely on your clear investment philosophy and investment process.
For predominately strategic asset allocation (SAA) investors, that means relying on diversification. Exposures to cash, sovereign debt, high quality fixed interest play an important role in SAA portfolios. That role came under serious challenge through January. Longer-dated bond yields surged and drove capital losses in portfolios. The importance of having some downside protection against uncertain outcomes is highlighted by the recent market movements. As is the critical importance of rebalancing portfolios after significant asset moves such as we saw through 2021.
For dynamic asset allocation (DAA) or active investors, the challenge is to push back against the temptation to make short-term portfolio changes. Instead, it is important to rely on process. For us, that means:
1. Review scenarios that could materially change the medium-term outlook.
2. Review the existing medium-term outlook against those scenarios.
3. Consider whether the portfolio will need adjusting if those scenarios materialise.
4. Adjust the portfolio, if necessary, when we get more clarity about the Russia Ukraine conflict outcome.
Importantly, we recommend being aware of sell-the-rumour, buy-the-fact events. Previous conflicts that have driven episodic widening of risk premia have been followed by rapid narrowing of risk premia after the uncertainty has declined. In other words, as the negative news flow grows, investors may price in ever-more negative outcomes. They may become overly pessimistic. Subsequently, even a relatively bad absolute outcome can be better than market expectations – and result in a perverse increase in equity prices.