While we don’t see this conflict as kicking off new rounds of 1970s-style stagflation, disruptions to the commodity trade are a risk for inflation.
As the Russia-Ukraine conflict intensifies, market volatility remains high. Investors are trying to grapple with the direct impact of the conflict on European and global growth, but also the more impactful indirect aspects of higher commodity prices, uncertainty and reduced risk sentiment, plus the lingering tail risks from potential escalation.
That said, the macro mix is now decidedly less positive, with higher headline inflation and lower growth on the back of higher oil prices. Ahead of the Russian invasion of Ukraine most data through February suggested the global economy was on a path to accelerate into Q2 as Omicron fades. However, we now see near-term downside, particularly in Europe, with higher commodity prices and inflation as the main transmission channel to weaker growth. If oil prices sustain at current levels our U.S. forecasts could also come down slightly. From a policy standpoint, our current expectation is that the impact of growth and inflation shifts is roughly neutral for the Fed, leaving our view unchanged, but raises some risk of a delayed ECB exit.
The runway for a soft-landing of the U.S. economy is now decidedly shorter and narrower. The chance of a policy error has increased: Fed tightening in the face of higher inflation (but weaker growth) raises the risk of ending the cycle prematurely. On the other hand, looking through energy-induced inflationary pressure raises the risk of inflation expectations becoming unanchored. Indeed, the market has already moved more dovish with the possibility of a 50bp hike in March largely priced out. Recent Fed communication has been clear: they will likely focus on inflation and proceed with 25bps in March and continue with balance sheet reduction later in the year. Powell said that the Fed is committed to bringing inflation back to target and would be willing to consider larger hikes if inflation were to remain elevated. So while we have the answer to what the Fed is prioritizing, we don’t yet know how the combination of tightening and uncertainty from war – plus higher prices – will further adversely affect growth.
From a portfolio standpoint – in equities we have broadly turned more defensive. We favor healthcare, particularly defensive segments of the sector (large-cap pharma, healthcare providers). This sector is a low-beta play on the market with mid to high-single-digit sales growth and low sensitivity to inflationary problems. We also favor commodity-linked segments (energy and materials) in an environment where commodity prices remain elevated due to their attractive valuations. J.P. Morgan Investment Bank revised their commodity price forecasts 10-20% higher across the board, and we’re now seeing oil prices moving towards $120/bbl in Q2, before settling back down towards the end of the year. Defense stocks also present a compelling opportunity; NATO members are committing to higher spending, there are attractive valuations, and there is a low sensitivity to inflation (governments are not price-sensitive so companies can more easily pass on costs). By region we favor the U.S. and China due to low earnings exposure to Russia/Ukraine. Parts of EM (particularly LATAM) can also benefit from higher commodity prices. We are cautious on Europe.
Outside of equities, we like adding commodities to portfolios as a hedge against further escalation. If sanctions or countermeasures put pressure on Russian commodity exports, commodities are one of the few areas of the market that may do well. Additionally, we continue to like alternative investments – both real assets as an inflation hedge and hedge funds (particularly multi-strategy) – for their ability to navigate volatility and provide uncorrelated returns. Similarly, absolute return strategies could also benefit in this environment from their low correlations with market performance.
Conflicts and investing : how to gauge the impact of this crisis
There are two schools of thought on the impact of geopolitics on markets: on one hand many analysts will recommend looking through the current conflict with the often-repeated axiom that geopolitical events rarely have a lasting impact on markets. The data certainly bears this out. Looking at the history of conflicts and crises, the vast majority of sell-offs present buying opportunities. Indeed, even the most famous investor himself, Warren Buffet, is quoted with (the unfortunately insensitive) saying “buy when there is blood on the streets.”
However, the counterpoint will tell you that a full-blown conflict with one the world’s largest energy producers is a different situation than we’ve seen in the past, and the risks emanating from an energy price spike or larger conflagration could create either unintended consequences or further downside to growth and risk sentiment. Indeed, the few conflicts that did have a longer-lasting impact on markets involved energy producers – the Suez crisis, and the 1973 Israel/Arab war that resulted in an oil embargo. This view looks at the existing mix of slowing growth, already high inflation, and sees the risk of a 1970s geopolitics-induced stagflation.
The scenario that eventuates will largely be determined by how the conflict escalates, and particularly how the energy sector is impacted; whether there are unintended consequences from sanctions that create wider ranging disruptions; and lastly, what is already in the price?
We don’t take the sanguine view that this conflict will not have any lasting impact. While we don’t see this conflict as kicking off new rounds of 1970s-style stagflation, disruptions to the commodity trade are a risk for inflation. As we mentioned above, we see enough of an impact to lower growth and return estimates, while raising inflation, and now expect higher volatility to persist. This leads us to a more cautious risk exposure (but decidedly not over-allocating to cash).
1. What factors could shape the outcome?
The fog of war is real and the potential next steps taken by the many actors in this crisis create a wide range of possibilities. As a recap, we’ve already seen a dangerous spiral: an initial Russian invasion, a stiffer than expected Ukrainian resistance that’s forcing a change in Russia’s strategy, the U.S. and EU announcing major sanctions, NATO members beginning to supply Ukrainian resistance, and Putin putting nuclear forces “on alert.”
This leaves three scenarios for the coming period:
- Negotiations work and we have an off-ramp to peacefully resolve this conflict.
- Russia backs down, either due to a high-level change in strategy, or a result of domestic pressure.
- Russia escalates and achieves regime change and some level of control over Ukraine. This scenario could result in a number of outcomes, including a Ukrainian government in exile, or an insurgency and counterinsurgency.
Following this dangerous path of escalation we are left with two questions:
- How does the West respond to military escalation and increased devastation in Ukraine?
- How does Putin respond to devastating sanctions and Western military support?
The bottom line: We’re already seeing escalation, which creates a dangerous scenario where further sanctions or Russian countermeasures become a higher probability. While energy has been ring-fenced, the sector could increasingly come under the crosshairs from both sides.
2. What are the risks of unintended consequences from sanctions?
We’ve already seen a wide range of sanctions applied:
So far markets have been fairly sanguine in anticipating the dislocations that this set of sanctions could cause. But we are cautious for a few reasons. First, these sanctions are among the most impactful ever placed on such a large integrated economy. We are still in the early stages of understanding the impact and level of uncertainty they create among banks, traders, and market participants. Second, we have yet to see how the Russian government might retaliate, particularly whether they are willing to bear the economic costs of reducing the flow of energy or other commodities. Third, Russia is interconnected, unlike Iran, North Korea, or Venezuela. Russia plays a key role in many commodities, beyond just energy; if potash or neon trade is restricted, that could have knock-on effects to supply chains and economies far beyond initial expectations. Further, although overall exposure to Russia has declined since 2014, a Russian debt default still has the potential to shock the market.
3. What’s in the price?
The market has begun to shift from pricing a broad risk premium to dealing with a concrete reality, where risks across assets are starting to be differentiated on the basis of the market's view of the actual macro risks. RUB and Eastern European currencies are priced for a severe downside risk to a lesser degree. EM equities and European assets have reversed some weakness but are still pricing a high level of downside risk, as are oil prices. Other global assets—including U.S. equities, credit, and rates —are now incorporating a lower level of risk. Bond yields moved relatively little in the stress period last week than the other asset classes. With inflation already high, the market has been less convinced that central banks will likely be easily deterred from hikes. But while equities have bounced meaningfully from their lows, U.S. yields are still lower, expressing the market’s lower conviction that central banks will likely “stay the course”, at least at the margin.
Two areas of dislocation stand out: first, there is the risk gauge of the impact of this crisis on higher oil prices. The uncertainty of sanctions, tight supply, and an unknown reaction from Russia could push the risk premium higher in the short term. Second, the pricing out of hikes could also reverse. The Fed came out with strong language that they will prioritize inflation, and the market may be overestimating the impact that the conflict will have on the Fed’s trajectory.
At the moment we don't see this conflict as the start of 1970s-like stagflation, but disruptions to the commodity trade are a real risk. The economic and market impact will be differentiated, but further increases in commodity prices will have a negative impact. Elevated inflation and market volatility will likely persist for longer from here. We take a selective view of adding risk to a portfolio at the moment, but would also avoid cash. Investors may look for opportunities across commodities, defensive equities, absolute return strategies and alternative investments for returns and protection.
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