War, COVID-19, inflation, interest rates: Could ETFs protect portfolios?

When news of Russia launching a series of separate attacks across Ukraine broke on Thursday last week, the Australian share market plunged.

As investors braced for all out war between Russia and Ukraine, by the close of trade the S&P/ASX 200 index had tumbled ~3% or 215 points to 6990.6 points, with ~$73 billion wiped from the local bourse.

Heavy falls were also felt across global markets. This week the ASX and its international counterparts have trended higher as investors shrugged off geopolitical risk.

But with recent sanctions targeting major Russian financial institutions and companies enraging President Vladimir Putin, who has ordered his nuclear forces to a higher state of alert, BetaShares chief economist David Bassanese said markets will remain volatile.

Restrictions include Russian access to the SWIFT system of international payment messaging, which will hamper Russia’s ability to earn export receipts and pay for imports.

“Also pivotal was the decision of several countries, including Germany and the US, to provide military equipment to Ukraine,” Bassanese said.

“These new sanctions pose the risk of disruption to Russia’s significant exports of gas, oil and agricultural commodities, which would only exacerbate current upward pressure on global inflation.

“There is also the growing risk of spill over from likely extreme movements in Russian financial markets, and a potential Russian sovereign debt default.”

Near-term investment implications

Bassanese said the escalation of the situation in Ukraine has caused an increase in the equity risk premium and, in turn, a market drawdown.

He said the escalation of tension in Ukraine has been accompanied by rising energy prices, and with the risk of Russian energy sanctions persisting, this could drive up oil and gas prices further.

Global equities with an exposure to Russia could also have implications.

“The potential sectors of interest in this sea of near-term uncertainty remain energy and gold exposures, though we would note the stock specific risks and need for diversification when investing in global equities in the current environment, some of which may have exposure to Russian assets,” he said.

So how do investors protect their portfolios during times of geopolitical tensions like Russia and Ukraine? Bassanese said ETFs are often a good option with exposure to a range of sectors and companies which could trend higher.

Exposure to the price of crude oil futures and the energy sector is possible through BetaShares Crude Oil ETF (ASX:OOO) and the BetaShares Global Energy Companies ETF (ASX:FUEL) respectively.

Higher world food prices

“Russia and Ukraine account for one quarter of global grain exports with any war-induced disruptions to supply potentially driving up high world food prices – which in turn could boost profits for other producers,” Bassanese said.

He said exposure to the world’s top food producers is possible through the BetaShares Global Agriculture Companies ETF – Currency Hedged (ASX:FOOD).

Gold security

Gold is considered the safe haven of choice during periods of market uncertainty as a store of wealth that provides greater security.

High inflation and war uncertainty has seen gold prices lift of late to ~US$1905 an ounce.

Exposure to gold is possible through the BetaShares Gold Bullion ETF (ASX:QAU).

Bassanese said for those fearing a deeper equity market correction, and wanting to hedge their equity positions against such an eventuality, other options are available through a range of short funds, such as BEAR, BBOZ and BBUS.

“These funds are designed to generate returns that are negatively correlated to the returns of either the Australian or the US sharemarket,” Bassanese said.

He said another potential safe haven exposure is the US dollar, which could rise if there is a global liquidity squeeze.

Exposure to the US dollar, versus the Australian dollar, is possible through the BetaShares US Dollar ETF (ASX:USD) and the BetaShares Strong US Dollar Fund (hedge fund) (ASX:YANK).

Not all grim news

While near term volatility is likely to remain, Bassanese’s assessment is that the Russian-Ukraine crisis shouldn’t significantly disrupt the longer-term global economic and financial market outlook.

He said this is due to several factors including the relatively small size of the Russian and Ukrainian economy, which comprises 2% and 0.1% of global GDP respectively. Russia’s economy is roughly the size of Canada’s.

He said the fact that global corporate earnings growth to date remains solid and the global economy is continuing to recover from COVID restrictions was also a promising sign.

“Based upon past confrontations, it’s the uncertainty leading up to conflict that has tended to do most damage to markets,” Bassanese said.

“Once the event itself happened, the earlier ‘event risk’ priced into markets has tended to dissipate somewhat as the uncertainty receded.”

Interest rates & inflation concerns

While the threat of war to markets remains, Bassanese sees high inflation and tight labour markets in countries such as the US as a greater concern. He sees a bit more of a correction to still possibly come.

“Barring a US recession, which still seems unlikely for at least the next year, a market correction of around 10-20% over coming months remains my base case, but not a lot more,” he said.

“In the US, the S&P 500 has already fallen 10%, though technology exposures, which are more sensitive to interest rates.”

The US Federal Reserve has indicated it will progressively raise interest rates this year from what are still near-zero levels.

“Equity valuations are coming under downward pressure as interest rates rise, but so far at least, earnings growth is holding up and should provide an offset,” Bassanese said.

He said a large element of these interest rate increases, moreover, is already priced into the market and further upside in long-term bond yields – which particularly affect the growth/technology sectors – should be limited.

“My base case is that US 10-year bond yields will reach 2.25% in H1 2022, from recent highs of around 2% – but they have already lifted from around 0.5% since mid/late 2020.”

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