What has happened?

The images on the evening news were a stark contrast. On the one hand, Australian families fell into one another’s arms as the country finally reopened its borders, while on the other, Russian President Vladimir Putin shocked the international community by recognising the independence of two separatist regions in Ukraine and directing his military to enter the Donbas region for “peacekeeping” operations.

Mr Putin’s accompanying TV speech was long and emotional. Most ominous for the international order was that Mr Putin questioned Ukraine’s status as an independent state, revisiting history in such a way that it was surprising he did not order a full invasion of Ukraine on the spot. Unfortunately, history tells us that dictators don’t tend to soften with age, which might not bode well for other former Soviet countries. The more short-term risk is that separatists in the Donbas region profit from the implicit support of the Russian military to move forward by themselves. This could potentially lead to an unwanted escalation and direct confrontation between Ukrainian and Russian forces.

At the time of writing, the US reaction was a rather muted one, announcing very local sanctions on the Donbas region and forbidding US persons and companies from doing business and investing there. US President Joe Biden clearly does not want to give Mr Putin a reason for even more aggressive action. In this regard, it seems that Mr Biden’s long-term experience on foreign policy and handling Russia is positive news. It remains to be seen if the summit announced between US Secretary of State Antony Blinken and Russian Foreign Minister Sergei Lavrov still materialises this week. But stronger military action would make such a meeting less likely.

While EU leaders have yet to come up with sanctions, it seems that for once there is some kind of agreement, despite the quite variable dependencies on Russian gas and the economic consequences of a further rise in already skyrocketing gas prices.

What was the market reaction?

• As expected, markets moved into a risk-off environment in the wake of this news, with the S&P 500 down 1.44% while the Euro Stoxx 50 lost 1.22%. This morning, futures are also well into red territory, with the S&P 500 losing 1.7% while the Euro Stoxx is expected to open 1.5% below yesterday’s level.

• Safe-haven assets outperformed, with government bonds trending higher – US 10-year Treasury yields retreated to 1.86%. The gold spot price USD/oz breached a long-term resistance level to rise above USD 1,910, while the CHF appreciated against the EUR to around 1.035. This morning, Japan’s Nikkei index is down 1.7% while the Hang Seng index has plunged 3.2%.

• The oil price added a few USD to reach around USD 94 a barrel on the WTI generic future. All in all, market reaction still remains disciplined even though more volatility can be expected as the political and military situation evolves and potentially escalates.

What does this mean for asset allocation?

In the Multi Asset Fundamental Investment Committee, we moved to a more cautious stance in the last quarter of 2021. This shift was based largely on our perception that central banks were late in normalising their policies to the inflation risk. In addition, we viewed the Ukrainian situation as a non-negligible tail risk, and so we adopted a neutral-plus view on equities and a cautious stance on bonds, while favouring commodities. With the escalation of the Donbas crisis, we have also moved our equity exposure back to neutral, while upgrading gold and US Treasuries as safe havens.

In the last weeks, market cycle indicators on risky assets also declined substantially from a positive to a much more cautious stance, with only the UK FTSE remaining in positive territory.

In summary, this means that in most of our book of business, we have reduced our exposure to risky assets, added to safe havens including cash, and adopted a more cautious position. Obviously, markets could remain volatile over the coming days with large intra-day swings. Commodities are the only asset class we feel very confident about currently: they profit from the world reopening as the Omicron variant fades and inflation continues to bite, while being positively correlated with the uncertainty around the Ukrainian situation.

Equity markets are likely to remain challenging and have been focused more on the military escalation in Ukraine than on recent central bank announcements. It will take very solid earnings and a cooling down of the situation in the Donbas region to spark a recovery. Finally, government bonds are a safe haven only for as long as the crisis in Ukraine persists. In the medium term, we continue to expect central banks to normalise their monetary policy on higher inflation data, which will negatively affect the bond markets. But then it will all depend on Mr Putin’s next move.