Fund Positioning in Light of Russia’s Invasion of Ukraine

Due to the Russian invasion of Ukraine, on the 24^th February, we have to consider its effect on financial markets, and the economic sanctions against Russia and Belarus.  A regional war in Europe has an outsized material impact unless it can be viewed as an isolated impact with little change of contagion. 

This war is a short-term impact.  Now is not the time to panic and sell equity just as we are on the cusp of a global recovery.  The markets have already weathered heightened geopolitical tensions in the past, and two years of a global pandemic.  Looking back in similar points of such tension in history, equity has tended to recover after a period of bear with positive 1-and 2-year returns.  Such volatility in markets, particularly when unrelated to the long-term economic realities of fundamentally-strong investment, should be as potential opportunities. 

Additionally, global growth and company earnings are likely to remain strong this year while monetary policy normalisation will be more gradual than what many market participants have projected.  This is largely due to the immediate impact of sanctions.  On the contrary, current market volatility offers an excellent opportunity for us to increase equity allocation at a discount.  None of us can confidently call when the market will bottom out.  This means it would be prudent to execute a strategy of gradual increase in equity stakes of select funds.  The macroeconomic outlook does not change.  There will be a disconnect between the underlying worth of the market and their price.  Now is the time to take advantage of that dislocation. 

Here are some facts to consider in light of sanctions, so there is some perspective.  Russia accounts for around 13% of global oil production, and 17% of global natural gas production.  This makes Russia the largest single producer of energy in the world.  As such, the conflict has raised natural gas prices.  Oil prices regained the US$100 mark for the first time since 2014.  The spike in energy prices has compounded broader inflationary concerns that have troubled financial markets.  There will also be an impact on other commodities such as wheat because Russia is the world’s largest exporter, and Ukraine is one of the world’s largest exporters.  Russia’s invasion of Ukraine will fuel a rise in inflation.  Sanctions will make it worse.  This complicates central bank decisions on interest rates and monetary policy. 

In light of this, where do AIA funds stand?  All AIA ILP funds have limited exposure to the energy sector.  AIA Elite Funds and AIA Global Dynamic Income have less than 1% exposure to Russian and Ukraine securities while the rest of other ILP Funds either do not have any direct exposure or have negligible exposure to Russian and Ukraine securities at the time of writing.  Neither Russia nor Eastern Europe have been central to our investment strategy. 

We have had 2 years of the Covid-19 pandemic.  Global recovery has since been strong on the back of unprecedented liquidity and significant policy support from major central banks.  2020 was extremely volatile because it is unprecedented in modern finance.  2021 was seen as a year of recovery.  Major indices saw double-digit returns; the MSCI World index rose 22.3% and US S&P 500 rose 28.7%.  Vaccination programmes and easing of lockdowns further spurred global growth.  There was a spike in consumer demand for goods resulting in strong corporate earnings.  This fed higher inflation and strengthened the labour market. 

Since 2022, inflation is well above the Federal Reserve’s target of 2%.  The American consumer price index rose 7% in December 2021 from a year earlier.  This is its fastest pace since 1982.  As such, the Federal Reserve was already expected to take more aggressive action to curb surging inflation.  The Federal Reserve’s current quantitative easing asset purchase program will end by March 2022 as they taper purchases.  There will then be a likely balance sheet reduction, leading to a reduction in the nearly US$9 trillion in assets the Federal Reserve is holding .  Of that US$9 trillion, around US$8.3 trillion comprises of Treasuries and mortgage-backed securities.  The expectation that the Federal Reserve would engage in triple policy tightening has shaken the market on worries of an economic slowdown.  The markets are concerned because it is uncommon to have the Federal Reserve taper so rapidly, lifting interest rate, and reducing its balance sheet simultaneously.  Previously, these actions were taken with intervals in between so that the market can adjust. 

In anticipation of this, AIA Elite Funds are well diversified across a combination of global equities and global fixed income funds.  Asset allocation decision remains one of the largest drivers when determining the range of outcomes.  Underlying allocation of funds are monitored and reviewed on a regular basis.  Adjustments are made accordingly to best position the fund to capitalise on opportunities ahead.  These opportunities have been outlined above, and in previous articles. 

Consider this: During the onset of Covid in 2020, it was recognise that certain stocks will benefit the Elite portfolio from the lockdown and working from home.  Our fund managers anticipated that change in consumer behaviour.  They, therefore, increased exposure to the Growth strategy fund that Baillie Gifford sub-manages.  Since November 2020, Covid-laggards, value and cyclical stocks, have caught up to growth stocks, which vastly benefitted during Covid.  In view of this, our fund managers increased exposure to a more value-style tilt, and rebalanced the factors exposures within multi-factor equity funds.  As the Federal Reserve continues to tighten and real rates trend upwards, its high correlation of value-over-growth outperformance is implies more upside to value.  We should expect such trends to continue well into 2022.  At the beginning of 2022, our fund managers increased our exposure towards value. 

Our investors, with an extended investment horizon, are expected to reap value as we ride the recovery wave expected.  The situation in the Ukraine does not have a lasting impact on our portfolio due to negligible exposure.  Our only concern is inflation, and the measures to address them.

If English Made Any Sense ...

Douglas Lincoln Larson, the American columnist, said, “If the English language made any sense, lackadaisical would have something to do with a shortage of flowers.”  He also said, “If the English language made any sense, a catastrophe would be an apostrophe with fur.”

Economic Insights for March 2022

The following is our investment analysis for March 2022.  The market, at the moment, is largely shaped by the Russian invasion of Ukraine on the 24^th February, and the consequences of sanctions.  A regional conflict in Europe has an outsized impact on the market. 

At the moment, there is hope that peace talks will put a quick end to the conflict.  The Russian invasion has bogged down, and any hopes of a quick decapitation of the Ukrainian government has long passed.  Even then, this has had a serious impact on risk sentiment.  What is certain is that there will be continued sanctions by the West, and countries aligned with it.  This will make international trade complicated in the next several months, which would dampen hopes of a quick recovery to pre-pandemic levels. 

There are inflationary pressures caused by the spoke in energy costs, a direct result of sanctions.  This adds to concerns of a new variant virus which may lead to international closures.  Governments are also raising consumption taxes to address the costs of the economic shutdown.  These confluence of events have central banks on edge.  There is danger of a second round effect, chief of which is the wage-price spiral, a perpetual cycle where rising wages create rising prices and vice versa.  Ordinarily, central banks would use monetary policy, and fiscal policy to curb this.  This is not as effective when we are dealing with the effects of sanctions.  Russia was the largest energy supplier in the world, and the primary supplier of gas to Western Europe. 

In the meantime, China has been easing its monetary policy in tandem with a shift in Covid strategy from “Covid-zero” to “dynamic zero”.  China has recognised that a total lockdown is not an effective tradeoff.  Hong Kong is an example of the worst effects of this policy.  There is support from state-backed funds to buy China A shares, which are early signals of a sustained recovery. 

Monetary policy normalisation accelerated further, all over the world, in the first two months of 2022 with several key central banks announcing more interest rate hikes over a shorter time period than expected only a few months ago.  This was to address rising inflation.  On the other hand, China is in a different position.  Because of its Covid-zero strategy, there has been months of subpar economic activity.  The result is that consumer inflation is contained.  To address this, monetary and fiscal policies have been eased in order to stabilise investor sentiment and promote growth.  This is not enough, we expect more to be done.  The Chinese economy is still facing challenges.  They include regulatory uncertainty, macro-deleveraging and continued restrictions related to Covid-zero. 

Asset allocation decisions still remain as one of the largest drivers when determining the range of portfolio outcomes amid volatile markets.  The short term geopolitics and earnings revisions of Asian markets have started to look more favourable.  However, in light of the effects of sanctions against Russia, we need to keep a close eye on the market. 

Profit margins and returns on equity have continued to reach record highs for all markets, especially the United States.  The Treasury yield curve is unlikely to invert in the near term.  While inflation is a concern, the possibility of recession continues to recede.  As the year progresses, there should be an upturn in the market in the near term, and equities will start to outperform bonds, and start to gain in value. 

When it comes to equities, if the situation in Ukraine does not escalate, and spread, we should expect above-trend growth among major developed economies to continue, at least the first half of 2022.  This would supports the momentum earnings growth and would be more resilient against expected Federal Reserve hikes to equity valuation.  However, earnings growth is projected to slow down.  That being said, the earnings outlook of Asia excluding Japan companies improved.  They are projected to outperform developing markets.  China is expected to provide more policy support to bolster markets after the recent regulatory crackdown.  This also means a projected recovery of credit growth.  Further good news is the reopening of ASEAN economies amid accommodative monetary policies. 

Investment grade credit spreads have widened significantly over the last two months.  In mitigation, against their own histories, the spread moves remain tame.  We are in a rising rates environment.  As such, the performance of some of these bonds is likely to suffer.  In a sanctions environment, we do not expect material tightening of credit spreads from the current level.  Preference should be given Asian credit over US credit.  We have to consider the credit spread premium Asian credit against US credit, particularly against the backdrop of diverging monetary policy by key central banks in the West versus the People’s Bank of China. 

On Treasuries, we have to consider that the Federal Reserve’s new pivot to fighting inflation expectations means short rates will move upwards quicker than the long-end, causing the yield curve to flatten.  This is overdue, considering the high inflation.  However we do not see any inversion happening in 2022.  Over the medium horizon, we should expect higher rates volatility and weaker price performance.

Quora Answer: Should My Assets be in a Revocable Living Trust?

The following is my answer to a Quora question: “Should my assets and investments be in a revocable living trust?” 

A revocable living trust is not a distinct legal entity.  The advantage is that assets in the trust are readily available to you, for you to dispose or manage as you see fit.  The disadvantage is that it does not provide any protection against claims against your person, nor does it mitigate your tax exposure. 

The primary use of a revocable living trust is that it provides a structure to ensure the management of your assets in the event of disability, or loss of faculties.  The trust becomes irrevocable at that point.  Another benefit is that any revocable trust becomes testamentary and irrevocable upon your death.  This allows your estate to disburse to assets to beneficiaries across an extended period, upon the fulfillment of specific conditions that you set out in your letter of wishes.  If these are your considerations, then should look into it.

Quora Answer: How Many Business Advisors Do You Need?

The following is my answer to a Quora question: “How many business advisors do you need?” 

Many companies fill their boards with “business advisors” for strategic reasons, access to markets and networks, for marketing and branding purposes, and many other reasons other than for their actual advise.  But if you are talking about an actual business advisor, you only need one.  Having more than one business advisor would mean conflicting advise, confusing the board, and perhaps, paralysing them into inaction. 

Just as a ship needs only one captain, it is preferable to have only one business advisor.  Some may believe that it is better to have several, so that there is a range of perspectives.  This is unworkable.  What happens is that some business advisors get sidelined, and it breaks that relationship.  People, by nature, are more agreeable to advisors that support their cognitive bias.  This would lead to a situation where these group of advisors, seeking approval out of self-interest, end up telling you what you want to hear, not what you need to hear.  Comfortable in the wisdom of these advisors, mistakes are then made.

Quora Answer: Can a High Tax Rate Decrease Inflation?

The following is my answer to a Quora question: “Can a high tax rate decrease inflation?” 

Managing tax rates is part of fiscal policy.  Increasing taxes curbs spending since the cost of consumption goes up.  This reduces demand for goods and services.  Reduction in demand leads to an easing on inflation.  Done properly, a higher tax rate can decrease inflation.

Quora Answer: Which is Better: an Exchange-Traded Fund or a Mutual Fund?

The following is my answer to a Quora question: “Which is Better: an Exchange-Traded Fund or a Mutual Fund?” 

On the surface, they are similar since both types of funds consist of a mix of different assets, making them cost effective means of diversifying a portfolio.  The biggest difference is that exchange-traded funds can be traded intra-day, like stocks.  Mutual funds can only be purchased at the end of the trading day, at a price calculated from the net asset value. 

There is no “better”.  Both mutual funds and ETFs have a place in a portfolio, and address different needs.  For one, mutual funds tend to have a higher minimum investment requirement.  This makes ETFs more accessible to smaller retail investors since an entry position costs far less.  Part of the reason why mutual funds have that higher minimum investment requirement is because they have higher management fees because many mutual funds are actively-managed.  The fund needs to beat the market for the fund manager to earn bonuses.  ETFs tend to be passively managed.  Additionally, mutual fund transactions are directly between investors and the fund.  The price of the fund is not determined until the end of the business day when NAV is calculated. 

ETFs are created or redeemed in large lots by institutional investors.  These shares trade throughout the day between investors, like stock.  It does not need to go through the fund manager.  This means, like a stock, ETFs can be sold short.  As such, ETFs are favoured more by traders and speculators, while mutual funds are for long-term investors.  But because ETFs prices change throughout the day, trading can take place at a value other than the NAV, allowing arbitrage. 

In summary, if you actively trade, and engage in price speculation, then ETFs suit you better.  If you are an investor with a longer investment horizon, then mutual funds are where you want to put your money.

Quora Answer: What Should be Considered Making an Investment Decision on a Market in 2022?

The following is my answer to a Quora question: “What are the factors to be considered while making an investment decision on a stock market in 2022?” 

Any investment decision made this year has to account for two major considerations: the first is the rate of inflation due to supply chain challenges, and the second is the rising cost of energy due to sanctions and disruption of global oil and gas supplies.  Their effects are global and this has lead to a depression in equity values.  Bond yields have not risen appreciably due expectations that the rates would be raised to combat inflation.  And then Russia decided to invade Ukraine, and so there is uncertainty in the market. 

Any investment that has an extended investment horizon should minimise movement if they are invested in East Asia and Southeast Asia since these are still the growth regions of the world in the long term.  Europe is in a mess, with the ECB unable to coordinate any coherent policy in a timely manner to address immediate challenges.  Western Europe is dependent on cheap Russian gas and oil.  The sanctions they slapped are not helping them.  This is not a problem that will go away anytime soon, even if Russia stopped its invasion right now.  The United States is amidst a massive infrastructure rebuild, but the real opportunities in technology will eventually be stymied because the administration seems intent on another collision course with China. 

For the short term, the real money is to be found in funds that invest in energy and commodities such as ores.  There is a global supply chain bottleneck that has raised their price.  There is also a shortage of chips and transistors.  In these areas where demand outstrips supply, we are looking at record profits.

Quora Answer: What is a Deferred Asset?

The following is my answer to a Quora question: “What is a deferred asset?” 

A deferred asset is simply any expenditure made in advance, and yet to be consumed.  This could be due to a short consumption period, such as any purchased item expected to be consumed within months.  This deferred asset would be recorded as a prepaid expense, so it appears in the balance sheet as a current asset first.  Or, conversely, this could be due to a long consumption period, such as any purchased item that is consumed over several reporting periods.  In such a case, the deferred asset would be recorded as a long-term asset in the balance sheet instead. 

We treat these expenditures as deferred assets to give a better picture of costs.  Otherwise, items with short consumption periods would be charged as an expense before their benefits have been consumed, resulting in inordinately high expense recognition.  Items with long consumption periods would show excessively low expense recognition in the later reporting periods.  Accounting for deferred assets does not apply to businesses which uses cash basis of accounting, because all expenditures are recorded as expenses as soon as they are paid for.  The most common examples of deferred assets include prepaid insurance, prepaid rent and leases, prepaid advertising, and costs related to corporate bond issuance.

Quora Answer: How Can Terrorism be Completely Eradicated?

The following is my answer to a Quora question: “How can terrorism be completely eradicated?” 

Terrorism is a political tool, a means of asymmetrical warfare, where a militarily weaker force engages in the calculated use of violence or the threat of it as a means of coercion and intimidation.  The intent is always a political goal.  The rhetoric often utilises ideology or religion to justify these acts, and gain support from elements of the population already disenfranchised or disenfranchised by these acts of terror.  As such, as long as there is an asymmetric sharing of power in any political system, and the weaker party sees no means to address that within the structure of that system, terrorism will always be a viable tool.  It can never be completely eradicated.

Quora Answer: How Can I Convince Venture Capital to Invest in an Original Accelerated Language Teaching Method?

The following is my answer to a Quora question: “How can I convince a venture capitalist to invest in an original accelerated language teaching method?” 

Venture capital invests in startups that can scale easily, and capture market share.  They are generally looking for a quick exit, or opportunities to cash cow through multiple rounds of funding.  Your pitch needs to address these conditions.  Can you demonstrate that there is such a market to be exploited, which does not have heavy competition?  Can you demonstrate that your product is scalable?  Can you demonstrate that there is potential for revenue growth over an extended period of time, thus justifying further rounds of funding? 

You are pitching an original accelerated language teaching method.  Which language or languages are you offering for a start?  What is the market, and why would they use your product as opposed to established alternatives?  What is the growth potential of that market?  When we consider these, the numbers are not enough to attract most venture capital.  You need to think outside the box.  Who would need to learn languages quickly?  Your market is not tourists, or casual students.  Your market is people who need to be in a country quickly, and knowing the rudiments of the language is very useful.  This would be negotiators of any kind, foreign service staff, and the intelligence services.  You are better off repackaging it, and offering it to the government, either by yourself, or in partnership with an established plater through some sort of licensing agreement.  Once you have established yourself firmly in this niche market, and that would take around three to five years, you can consider some form of expansion.

Quora Answer: Is It a Good Idea for a Small Business to Invest Some of Their Reserves into Stocks?

The following is my answer to a Quora question: “Is it a good idea for a no-debt small business with a healthy balance sheet to invest a portion of their cash reserves into individual stocks?” 

If you are a small business, it means that you have a relatively limited revenue.  The idea of investing a portion of your cash reserves is sound.  This is because keeping it in the bank means your holdings will eventually decrease in value due to inflation.  On the other hand, you need those investments to be relatively liquid in case there are unforeseen expenses.  The concern with inflation also precludes any form of debt instrument.  That leaves equity. 

However, putting it in individual stocks is a risk.  You are tying the value of your investments to the performance of individual counters on the market, subject to all the risk exposure that individual stocks bring.  You likely do not have enough to meaningfully diversity those holdings.  What you need is an investment that is liquid, sufficiently diversified to mitigate risk exposure, and gives a return that is above inflation.  It would be more reasonable to invest in some form of index fund or mutual fund.  That fulfills all the conditions.