Caution amid prolonged Ukraine war and heightened US-China tensions

How do narratives of conflict and geopolitical strains impact market movements?

This has become an interesting question in light of the Russia-Ukraine war and persistently high tensions between the US and China.

War propaganda can shape the course of conflicts, and recent history provides us with plenty of examples. During the Second World War, for example, as the United Kingdom struggled to resist the assaults of Nazi Germany, Prime Minister Winston Churchill made every effort to persuade the United States to enter the conflict. To this end, British intelligence officer William Stephenson, who anecdotally was the real-life inspiration behind the James Bond character, opened a propaganda office in New York responsible for “selling” the war to American voters.

Between 1940 and 1941, Stephenson planted as many as 20 imaginary tales of British bravery in the US media every week. These efforts proved quite effective in shifting the opinion of the initially reticent American public, as illustrated on the chart below. After the Second World War, intelligence agencies proliferated throughout the Eastern and Western blocs, as cold war belligerents competed to expand their respective spheres of influence.

Today, it seems that politicians and media in both Russia and the West are planting the idea of an enduring and potentially escalating war in popular consciousness. Thanks to now abundant unclassified military documents, academics have uncovered common features of effective wartime messaging. One of the main elements consists of inflating the prominence of a conflict for one’s side, while discrediting the opposing point of view. Today, neither side is prepared to explore the other’s national or strategic interests in any depth.

A protracted conflict

History, too, teaches us that wars can often last and intensify. In 1914, soldiers in World War I marched towards the front anticipating a quick victory, only to find themselves stuck in the trenches for years. Back then, ‘modern’ artillery such as machine guns and barbed wires multiplied the number of fatalities, while conveying little advantage to either side. Today’s military arsenals contain even greater threats, including of course nuclear weapons.

Russia and the NATO alliance each have around 6,000 nuclear warheads divided into two categories. ‘Strategic’ bombs are the most powerful, with enough explosive charge to obliterate an entire city. Given the threat of ‘mutually assured destruction’ should one be deployed, global military powers then developed tactical nuclear devices with much less power. Russia has around 2,000 of these weapons and the US around 200. This category of weapon is perhaps even more dangerous in that the risk one could be deployed is higher. However, their use in any conflict would likely cause rapid escalation. Against this backdrop, and taking into account Russia’s still sizeable reserve of potential troops to draw upon, we see entrenchment of the current military conflict in Ukraine as the most likely scenario going forwards.

The impact of wars on financial markets is difficult to single out and measure. Yet, historical data shows that in addition to the tragic human cost, geopolitical conflict has a consistently negative effect on economic activity, as it hijacks capital, jeopardises production facilities, disrupts supply chains, erodes consumer consequence and delays corporate investments. In the particular case of the Russia/Ukraine conflict, for example, the Federal Reserve estimates that the heightened geopolitical risk will translate this year into a loss of 1.5% in world GDP and an increase of 1.3% in world inflation.

Defensive portfolios of high quality assets

We believe tensions between the United States and China are likely to persist, and that the war in Ukraine is likely to continue – and even possibly escalate. The worrying geopolitical backdrop will only worsen current high inflation, slowing growth and recession risks. In the US, the Federal Reserve delivered a third consecutive 75 basis point interest rate hike in September after August inflation data disappointed, and pointed to further tightening in the near term. In Europe, the first ever double-digit inflation figure since the launch of the Euro in 1999 was recorded in Germany this month, which will put additional pressure on the European Central Bank to accelerate its hiking cycle.

As a result, we have upwardly revised our expectations for central bank policy rates and lowered our near term growth expectations, while further reducing risk in portfolios. In fixed income, we have sold some of our positions in convertible bonds and reallocated the proceeds into US Treasury inflation-protected securities (TIPS). We have cut credit risk further by reallocating some of our high yield exposure into investment grade bonds. We have also bought Chinese government bonds and hedged them into US dollars, with the aim of increasing portfolio resilience in an environment where risks to interest rates in developed markets are still tilted to the upside.

We are even more cautious with regards to equities, and maintain our focus on quality and value styles. As regards regions, we have recently cut exposure to UK and US stocks, and increased holdings of more defensive Swiss companies. We have sought alternatives exposure within macro and trend-following hedge-fund strategies, while removing overweight positions in commodities and European real estate. We also continue to favour haven currencies, including the US dollar and Swiss franc.