Don't build investment case on geopolitics, advisers warned

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Don't build investment case on geopolitics, advisers warned
The Russian ruble has recovered dramatically despite the war and sanctions (Credits: Alexander Nemenov/AFP)

Morningstar's global chief investment officer Dan Kemp told FTAdviser signs such as the ruble's dramatic recovery despite the ongoing war and sanctions, indicated how difficult it was to build an investment case on a geopolitical case.

Instead, investors should look at valuations but with multiple possible scenarios in mind. Portfolios should broadly withstand both a global recession and an event such as longer much higher inflation than expected, he said.

"If we think about a reasonable investment horizon valuations are going to be the key driver of returns in most scenarios," he said.

"[But] if you just let yourself be guided by valuation then you tend to get concentrated in a few different areas and that can lead to a portfolio doing poorly in the short-term, which will then harm the prospects over the long-term.

When we think about a sharp slowdown in the economy it seems to me that that's not been priced in to most asset classes.Dan Kemp

"You have to have a portfolio that is valuation driven but is robust to a range of possible outcomes." 

In a research paper published in March, Morningstar posited the threat of triple R - recession, rising rates, and a loss in real household incomes - was growing but said this should not push investors into immediate action.

Since then, US economic growth unexpectedly contracted in the first quarter amid growing trade imbalances, rising inflation and supply chain disruptions, the FT reported.

US gross domestic product dropped 1.4 per cent on an annualised basis, down dramatically from the 6.9 per cent rise recorded in the fourth quarter of 2021.

Real test

"More people are now concerned about recession and fewer people are concerned about continuous strong inflation," said Kemp. But global recessions do not happen often, he added.

The real test will be what the longer term consequences of the war will be, he said. There is an immediate impact on supply and prices but longer term there will be an effect on security, governments being distracted away from addressing climate change to focus on energy, and food security and political security.

"The frequency of global recessions is low. It sometimes doesn't matter whether you have a technical recession or a transition from what has been a very rapidly growing economy to one that looks like it's slowing down a lot because of that demand destruction.

"There is a better than 50 per cent chance that we are seeing a slowing in the global economy."

But he said from an investment perspective, it was not as much about what was going to happen but what has been priced in and currently a sharp slowdown has not been priced in.

To us, it is about understanding the underlying risks to assets, whether that be economic or market-risk factors - not just volatility or correlations.Dan Kemp

"When we think about a sharp slowdown in the economy it seems to me that that's not been priced in to most asset classes.

"We see very high valuations in most assets across the world and that's typically not consistent with widespread expectation of a significant slowdown."

The reason the potential event has not been priced in is because things have been moving so fast since the pandemic investors may have not caught up yet, he said.

Central banks have been somewhat cautious in their tightening too, so there is uncertainty over when the current pulse will come to an end.

Adding value

In his report Kemp said when diversifying for a negative equity environment investors must understand the underlying risks to assets.

The report stated: "To us, it is about understanding the underlying risks to assets, whether that be economic or market-risk factors - not just volatility or correlations (as these can change quickly and drastically). 

"For example, corporate bonds and equity markets can behave very differently, yet both are susceptible to an economic shock (damage to corporate earnings could cause equity values to fall and bond spreads to widen).

"All else being equal, this offers less diversification than holding equities with an unrelated asset, such as inflation-linked bonds or nominal government bonds. The message is to diversify against fundamental risks and be very intentional with how you are diversifying if you want to reduce the impact of an economic recession."

To really add value, Morningstar said, advisers and investors should take a long-term view and consider whether they can benefit by buying into negative sentiment.

Investors should not engage in widespread selling based on fears of an economic recession but only really care about a permanent impairment to earnings and the price paid for those assets, Morningstar said.

"If the economic cycle dents corporate profits in the near term, we may have the opportunity to buy into the negative sentiment and ride it out until the cycle reverts. This is one of many areas where we can add value, by maintaining a long-term view when others won't."

carmen.reichman@ft.com