March – Volatility, uncertainty and the Ukraine conflict

It has been a rollercoaster of a month in financial markets, even before the recent escalation in Ukraine. On 3 February, Facebook’s market capitalisation fell by more than USD230bn, the largest single day loss in US stock market history. Just a day later, Amazon returned a large chunk of this loss to the Nasdaq with a USD190bn surge in market capitalisation, setting another record, this time for the largest single-day gain ever.

This heightened volatility regime persisted throughout February, fuelled by the ongoing crisis in Eastern Europe, which I shall not comment on here beyond highlighting the impact from an investment perspective. In summary, whichever way the confrontation evolves from here, the mere existence of a military conflict in continental Europe will continue to exert a deflating force on financial markets. One rare consensus among finance professionals is the dislike for uncertainty.

"One rare consensus among finance professionals is the dislike for uncertainty"

A Yale University behavioural finance experiment with monkeys is very telling in this respect. A group of animals were given tokens they could exchange for food from one of two experimenters. The first person would keep one apple on display and offer an extra apple to the monkeys half of the time, while the second would show two apples but hand out only one and keep the other for himself half of the time. Classic economic theory would suggest that the two ‘apple merchants’ should have even market share, as they offered a similar expected return of 1.5 apple. However, in practice, a vast majority of monkeys preferred to deal with the person who offered a 50% chance of a bonus, rather than the person that offered a perceived 50% chance of a disappointment.

Indeed, contrary to what economic theory assumed until the late 1970s, market participants are not rational in their decision-making. One strong and widespread bias is risk aversion, which is so deeply rooted that we apparently share it with primates. Thanks to what is referred to in behavioural economics as the Prospect theory, which was developed in 1979, all else being equal, an expected payoff with certainty is worth more than the same expected payoff with volatility. Put differently, for a vast majority of market participants, the level of satisfaction associated with a potential gain is inferior to the perceived pain caused by a potential loss of equivalent proportions.

"For the majority of market participants, the level of satisfaction associated with a potential gain is inferior to the pain caused by a potential loss of equivalent proportions"

In the context of financial markets, one way in which risk aversion manifests itself is through the willingness of market participants to overpay for insurance against uncertain events. Indeed, as per the chart below, realised volatility has in most occurrences fallen short of implied volatility in the last 20 years. As such, selling out-of-the-money options has been a popular trade among finance professionals willing to stomach volatility to harvest inflated volatility premiums.

The conflict in Ukraine is particularly prone to triggering risk aversion concerns, as it presents a great asymmetry of possible outcomes. On the one hand, a prompt resolution would consist of reverting to an earlier state, which represents a modestly appealing gain. In contrast, further deterioration of the situation could entail dire consequences of unknown scope. Market participants do not like such low probability, high severity events, as they are nearly impossible to model or price with any reasonable margin of error. This partly explains the high sensitivity of financial markets to Ukraine-related news.

The additional complexity surrounding such high-pressure situations is that they significantly increase the likelihood of mistakes, with the probability of unforeseen incidents increasing over time. The tragic shooting down of a Malaysian Airlines passenger flight amid the 2014 Ukrainian conflict is an example of such terrible consequences. Investors should be prepared to weather persistently high volatility conditions for as long as the high-stakes geopolitical instability persists. 

Against this backdrop, central bankers’ already tough job has become even harder. Persistent inflationary pressures are likely to be further aggravated by rising energy costs brought about by the situation in Ukraine, accompanied by a potential growth slowdown. The European Central Bank recently estimated that a 10% cut in gas supply to the eurozone could shave 0.7% off the value of goods and services produced in the euro area.

"Central bankers’ already tough job has become harder. Persistent inflationary pressures are likely to be further aggravated by rising energy costs, accompanied by a potential growth slowdown"

Inflation is already printing at alarming levels, with January’s CPI reading in Europe at a record high, and the US CPI release coming in at 7.5% year-on-year, its highest reading in 40 years. At such levels, inflation is not an abstract concept; it is real and painful to consumers. Yet raising rates aggressively to curb it could cause a potentially greater problem for markets accustomed to ‘free money’ and riled by geopolitical uncertainty. Beyond this, higher rates will do little to stop any Russia-related energy supply shock, and could exacerbate any growth slowdown, a risk that will trouble policymakers in Russian-gas reliant Europe more than their peers across the Atlantic.

"We find that prior equity sell-offs due to geopolitical events and military conflicts have typically been short-lived"

In this situation, which asset classes should investors favour? We have reduced risk levels in portfolios to reflect the current uncertainty and escalation risk. Nevertheless, we retain a small overweight to equities, which have typically done well in periods of early policy tightening. We find that prior equity sell-offs due to geopolitical events and military conflicts have been typically short-lived, with equities down as the conflict erupted but mostly up in the subsequent three and six months. We continue to prefer value and cyclical stocks (see top chart below), beneficiaries of reopening and higher rates and quality companies with pricing power. Healthy Q4 earnings reports have demonstrated strong sales growth and pre-pandemic margins despite cost pressures (see second chart below).

In fixed income, we have reduced our underweight to high quality fixed income by tactically adding to our sovereign debt and investment grade positions. We remain constructive on high yield, especially in the US, where risk premiums are wide and defaults low. We have moderated our overweight to Chinese sovereign debt on narrowing interest rate differentials, policy easing, slower inflows, and limited currency appreciation potential and added a small exposure to Brazilian sovereign debt denominated in reais. The rationale for this relates to Brazil’s commodity exposure, a policy cycle close to peaking at double-digit interest rates and its lower comparative exposure to geopolitical risk.

We have also added a broad exposure to commodities across portfolios, as sanctions on energy products, or supply constraints from Russia, cannot be ruled out. This exposure could also act as a hedge in the event of any further conflict escalation. We have also increased cash to overweight in conservative and moderate portfolio profiles, and we take advantage of the elevated volatility level and skew to add downside portfolio shielding through options strategies. Bear put spread collars (long a put spread and short a call), for example, can help hedge against tail risk scenarios at an affordable overall outlay (see chart below).

We also continue to seek opportunities to deploy capital to non-core asset classes, such as real estate, hedge funds and private equity, for clients with the means to forego liquidity.

I would like to conclude this Rethink the Month by inviting our readers to make sure they have safety measures in place. Recent volatility spikes find their sources beyond the conflict in Ukraine and are likely to outlast it. After more than a decade of central banks underpinning markets, we are moving back towards normalisation - not only in policy rates but also in growth, earnings and valuations. At Lombard Odier, in addition to increasing our hedges as described above, we have been preparing for this by amending our asset allocation and strengthening our investment team capabilities, as we seek to deliver outperformance in an era when active management will be increasingly important. 

Stéphane Monier