Here's is our latest update on the crisis in Ukraine from Erik Ristuben and a special investment leadership webinar recap from March 9, 2022.
Adam Goff, CFA
Managing Director, Head of Research
I'll start with sharing how our response to the events in Russia and Ukraine is taking shape and where our focus is as an organization. First, with our direct holdings in the region; second, how our teams are working together to deliver great insights to our portfolio managers, and finally, what we are doing to get on top of the indirect risks.
Let's begin with Russell Investments' plans for our Russian holdings. A lot has happened in a week as far as index changes. Last week, we noted a modest weight in our portfolios and the indexes. Now, of course, Russian securities are being dropped from MSCI Indexes. Russia will be excluded from all J.P. Morgan fixed income indexes on March 31. The bottom line is, and this is news to nobody at this point, we agree with the index providers; Russia is uninvestable right now.
Equity trading was supposed to kick off again today but has been pushed back. When it starts, we have no idea what lies ahead, but we are fairly certain it will not be a well-functioning securities market. Will there be transparent pricing? Will the markets be freely accessible? Will there be fair access to trading?
As the geopolitical developments, sanctions, the market, and index impacts have continued to come through; we have made up our minds on a couple of fronts.
First, Russell Investments will not allow direct purchases of Russian assets in our discretionary portfolios, whether that be equity, fixed income, or currency.
Secondly, as liquidity returns to these markets, we will be winding down our Russian holdings, working with sub-advisors to identify the right time to do so. Right now, as just about everything is valued at zero, we have no intentions to do a forced sale or a write-down. Still, we will look for opportunities to exit when trades can happen, when the pricing mechanism starts to function better, and, as always, look out for the best interests of our clients.
There aren't many more specifics I can provide as we don't know what will be possible tomorrow, much less weeks or months down the road. Still, hopefully, this makes the direction of travel clear, and I would hasten to add that these are not massive holdings anywhere in our funds.
Another area I want to touch on is how Russell Investments and investment teams are mobilizing around these events to ensure our portfolio managers have great insights and information to support portfolio decision-making and ongoing management.
It all starts with the market intelligence gathering we get from our trading desk. It is great to have a 24-hour global trading desk trading in every market and time zone and to work with dealers worldwide. They can glean and pass along extremely useful information around what is happening now and where things are trending, in addition to potential moves by regulators and other institutions that impact an ability to execute trades.
We are also tapping heavily into our network of manager contacts, including subadvisors to our funds and other managers we actively research. I have been speaking to our head of global equity manager research, and he mentioned he thought we had spoken somewhere in the neighborhood of 90-100 manager contacts in the last ten days, including weekends. From that, we can get a great understanding of where they see the biggest risks and opportunities and what shoe has yet to drop in certain market events. The sheer numbers and diversity of these investors we can tap enhance our quality of insight.
Finally, our tactical disciplines are continuing to function as always. In this type of market environment, even as we rely on the insights of our sub-advisors, we are always on the lookout for opportunities that may arise from panicky markets going to extremes. Our strategist team is leading the charge with this, continuously refining our macro-outlook and working with investment professionals to find compelling tactical opportunities in real-time.
Taken together, the combination of real-time information from our traders, timely insights from managers, and a tactical process seeking opportunities as they arise, our portfolio managers can stay on the front foot as they monitor and manage portfolio positioning through uncharted waters.
A significant area of focus now and in the days ahead is to get a strong understanding of the indirect risks in our portfolio from the Russia/Ukraine conflict. This means situations where companies listed in Europe, the US, and other parts of the world will be impacted immediately or down the road. This is a moving target as company after company announces major changes in their business in the region, thereby changing their strategy and positioning.
This indirect risk presents itself in many ways—revenue risk, asset risk, and supply chain risk. We have all seen stories about how the automobile industry losing access to palladium supplies from Russia could slow down production that was beginning to rev up again. We also have to consider and track the potential direct impact of sanctions on businesses and the real and opportunity costs of exiting markets in the current environment might be.
What is our goal in tracking these indirect risks? The bottom line is that we want to know where risk is most potentially damaging to our portfolios and clients. We want to ensure that managers respond effectively and that we are not inadvertently sliding into a high level of indirect risk.
Our starting point is with the subadvisors, where we can pay attention both to what they say and the trading activity as they adapt to the new environment and find new risks. The transparency of portfolio positioning can spur great conversations and new insights that may help us manage risk across the portfolio.
Beyond that, we are also seeking to develop independent metrics to evaluate risk specifically emanating from the conflict. We are getting useful data on revenue shares by country that can help us assess direct exposure, and our risk teams are busy creating new metrics that will quantitatively derive sensitivity measures that can detect where there are industries and names with hidden exposure or surprisingly high or low levels of risk emanating from the event. We will keep working as a team to develop and hone these tools to understand how continued conflict or even a worsening situation might dynamically impact portfolios.
As we gather this information and develop our insights, it will be helpful in several areas:
- As an additional lens to understand portfolio risk levels and help with ongoing risk management.
- It is important to test managers on whether they are really on top of this risk and detect blind spots in manager perspectives that could expose the total portfolio to more risk.
- It will also inform our active ownership where we will be seeking to use proxy voting and engagement actions to advocate for better transparency of risks and plans by company management to manage that risk.
So, hopefully, it is clear that we are fully mobilized to address risks of holdings, both in Russia and beyond, and looking for opportunities that may arise from the market volatility.
Megan Roach, CFA
Senior Director, Head of Equity Portfolio Management, North America
As you would expect from Russell Investments, our multi-manager, multi-style diversification means we get a huge cross-section of views when communicating with our subadvisors around the world. At the top-down level, we can find managers who continue to focus on their existing cyclical exposures based on the view that, despite the Russian invasion, worldwide growth is still on sound footing within the broader path of recovery from the COVID-induced 2020 recession. On the other side, it is also easy to find managers who argue that it's the deceleration or haircut in growth expectations, even if growth remains above trend, caused by both the Russia/Ukraine conflict and persistent inflation that should be the driver in incremental changes toward defensiveness from here. For our global equity and multi-asset total solutions, our internal cycle, valuation, sentiment process combined with this balance of views from our subadvisors means, so far, we have maintained a generally risk-neutral position relative to our policy portfolios with standard rebalancing in place to maintain it.
As mentioned last week, while market volatility is elevated with the VIX in the mid-30s, it is not at the levels seen during the GFC or COVID sell-offs, which topped out with the VIX in the 60-80 range. Also, while equity market returns are negative so far this calendar year, most of that, about 9% of the 12% YTD decline in the MSCI All Country World Index, occurred before Russia invaded Ukraine on February 24th.
So, instead of making any dramatic top-down calls within our total solution or equity fund positioning, we have been focusing on monitoring and understanding the largest contributor to active risk in our portfolios, which is our subadvisors' bottom-up stock selection decisions.
As they reconsider the outlook for each company in their portfolios, they are taking into account not only the unfolding events as they occur but making an assessment on a name-by-name basis on whether current market pricing is accurately reflecting, versus under or overreacting, to each company's circumstances. While the outcome and duration of this conflict remain very uncertain, we continue to believe that the selectivity of active stock-picking in a volatile market environment is as important as ever.
Over the last week, we have seen these bottom-up decisions accumulate into some interesting, albeit small, given our diversification shifts in-country and regional exposures. In our global equity portfolios, we've seen managers reduce exposure to Europe & UK by about 50 bps over the past two weeks, with capital redeployed toward North America, Japan, and various Emerging Markets countries far from the conflict in Eastern Europe.
We've seen some accumulated moves indicating trims in the energy sector and parts of the consumer discretionary and technology at the sector and industry level. At the same time, we've seen adds to aerospace & defense, other parts of technology, and health care companies, particularly as pent-up demand for elective procedures ramps this spring and summer. While not all of these moves are tied explicitly to the situation in Ukraine, there are some common themes arising in our discussions with managers that align to these incremental shifts.
On energy, the events of the past couple of weeks and particularly given yesterday's announcements by the US and UK to ban various Russian energy imports have driven the price of oil to around $120 per barrel. While this is still outside the $130-150 range that Erik highlighted as where things start getting problematic for the global economic cycle overall, there are still plenty of company-level repercussions that need to be taken into account by our managers.
On the surface, this could easily be seen as a boon for energy companies outside Russia that will pick up the slack in supply. However, it should be noted that the global energy sector has already been the best performing sector over the past year by a wide margin-- 30% outperformance globally over the MSCI ACWI and 40% outperformance of US energy stocks vs the Russell 1000. Accordingly, we've actually seen small trims across our portfolios as managers lock in profits in areas like US and Canadian energy stocks they consider already priced to perfection, especially as the logistics of actually ramping production and transporting various fuel types to replace the supply chain from Russia are sorted out in the coming months and years.
In addition to all of these decisions in the traditional energy space, another conclusion to draw is that this conflict solidifies the case for investments in renewables. This bleeds into decisions related to electric vehicles, where one of our best-performing holdings in our multi-asset funds last month was a US small-cap industrial company that was bought out at a 58% premium based on its leading global position in electric components for EV commercial vehicles. While the shift toward clean energy has already been underway, both the short-term needs and long-term consequences of this conflict are likely to drive even more demand and sentiment toward clean energy.
The second category of heavy review by our managers is how the consumer and discretionary spending will fare through this period where both the cost of money via interest rates and the cost of goods via inflation, particularly gas and food, are increasing. As one manager put in, "it can't be understated how much gasoline prices impact the psyche of the American consumer."
For consumer companies, whether it's restaurants, food staples, high end versus low-end retail, airlines, autos, or leisure, this again comes down to a case-by-case assessment of each company's specific input costs, supply chains, any raw material hedging strategies, demand elasticity, and pricing power. With the declining restrictions and stimulus related to COVID, managers have already been anticipating a move in consumer spending from goods toward services and, with these additional inflationary pressures, some managers are concerned that this could lead to retailers being forced into discount pricing going into the back half of 2022 if demand destruction takes hold. For autos, Russia as a major global supplier of the palladium and platinum necessary for catalytic converters, means high car prices are likely to persist even longer.
For retail holdings catering to the lower income brackets, there is a concern that higher gas prices will take an even bigger bite out of demand relative to higher-end retail, but one of our managers chose to add on recent weakness as they've witnessed in similar prior periods that these companies tend to have a natural hedge as they attract "trade down" customers that they are able to hold onto for subsequent years.
Another of our subadvisors noted that, until last Friday, airline bookings were accelerating quickly but, over the weekend, reversed course as both oil prices and nervousness about global travel took a toll on people's travel plans.
Next, moving on to technology, a couple of the big themes would be semiconductors and cybersecurity. With semiconductors, we've seen more trims than adds at the total portfolio level as managers assess the impact of Ukraine as a major exporter for key supplies in neon gas, krypton gas, and platinum which is expected to drive increased prices for the semiconductors produced but also elongate the current supply/demand imbalance that has existed throughout the pandemic. One manager noted that one semiconductor company they continue to hold has eight weeks of inventories and is rapidly assessing their ability to find alternative suppliers.
As Erik and our strategist team have mentioned, cyber-attacks have dramatically increased. As individuals, companies, and governments deal with these threats, there are many companies around the world who provide a vulnerability threat assessment, detection, and quarantining services that are likely to be in higher demand, as well as backup power solutions companies who stand to benefit from concerns related to power grid disruption.
The last area I'll touch on, as we have seen adds to the industry over the past couple of weeks, is aerospace and defense. Two other top performing holdings in our multi-asset portfolios during February came from this industry, including a defense contractor positioned to gain substantial revenue from Germany's decision to boost defense spending to more than 2% of GDP, as well as a satellite company whose imagery has been used to track the scale of Russia's deployment in Ukraine. As the EU evaluates additional means to boost defense spending in the coming years, this is an area our managers have been looking to generate new and creative ideas.
I do want to acknowledge the tremendous amount of work and oversight related to our clients' holdings and positioning in securities directly domiciled or traded in Russia, Belarus, and Ukraine that we've hopefully overcommunicated with you about over the past couple of weeks. I hope this additional detail and the examples I've shared help today highlight the extent of work going on, as always, across the rest of our global holdings where understanding the second and third-order linkages through global supply chains have been critical. As always, we believe periods of market volatility and uncertainty do highlight the benefits and relative peace of mind that comes with an active stock selection from our global network of subadvisors, as well as Russell Investments' oversight of your total portfolio to make sure risks and opportunities are well understood and managed.
We invite you to read our blog posts on the economic and market impact from the Russia/Ukraine conflict in real-time for our most-current views.
Held on March 2, 2022