Russia’s invasion of Ukraine fuels market volatility and global uncertainty
11 March 2022
Russia’s invasion of Ukraine is sending shockwaves across the globe and negatively impacting the financial markets worldwide. Russian President, Vladimir Putin, has sparked one of the biggest security crises in Europe since World War II by launching the attack on Ukraine.
The conflict has heightened tensions in relations between Russia and both the United States and Europe and this could further escalate if Russia expands its presence in Ukraine or into NATO countries.
Responding to Russia’s invasion, the United States imposed wide ranging sanctions on Russia which included Russian banks and elites, technology exports and no access to dollar, euros, pounds, or yen from a sovereign debt perspective. The European Union is banning the purchase of Russian government bonds and moved to sanction 23 high-ranking officials including banking executives, military chiefs, media chiefs and a top Kremlin official. Further, the West has made clear tougher penalties are to come. It remains unclear how much of an impact these measures will have on Russia, which is benefiting from high energy prices and high foreign reserves.
Implications for financial markets
Risk assets have fallen quickly, with US and European equities hitting new lows for the year. Government bond yields have declined but not as much as might be expected with such an equity selloff. Gold and other commodities (especially Energy) are rising. Oil and gas prices are spiking at a time when inflation is already high. Global benchmark Brent Crude oil futures topped $100 a barrel for the first time since 2014 and prices might continue to rise if the tension and military action escalates further. Russian assets have been hit hard on the prospect of more sanctions.
In our opinion, risk assets, including equities, may continue to face pressure in the short run due to geopolitical tensions (military action and sanctions). Russian financial assets may continue to be challenged. Energy prices (especially European natural gas) are expected to have the greatest macroeconomic impact, potentially exacerbating inflation.
Inflation, rates, employment, markets
2022 has begun on a cautious note, with markets experiencing a moderate pull back. Concerns about high inflation, the Fed turning hawkish, and geopolitical factors, including the conflict between Russia and Ukraine, all contributed to stock and bond market selloffs. In the midst of this global uncertainty, volatility has risen significantly.
As economies recover from the pandemic, inflation remains a major concern around the world. In the short run, the likely main macroeconomic impact of Russia’s invasion of Ukraine is higher inflation caused by rising energy prices.
In our opinion, inflation may remain elevated in the short term as markets grapple with the ongoing challenge of supply-chain disruption and added complication of high energy prices due to conflict. However, over the next 12 months, we expect inflation to subside as supply constraints ease and demand shifts from goods to services. In terms of monetary policy, we believe that markets have priced in rate hikes far too aggressively in the United States.
The situation in Ukraine is fluid and we believe our analysis remains accurate as long the war remains contained in Ukraine. Most wars trigger sharp selloffs in equity markets, but generally recover to pre-crisis levels within months.
Expect lower returns in 2022
Markets have had a stellar run as showcased by the MSCI ACWI Index’ strong returns over the past couple of years (27 percent in 2019, 6 percent in 2020 and 26 percent in 2021 respectively).
We expect the bull market will mature in 2022 with returns for global shares mean reverting to lower levels.
Dividends are expected to continue to rebound across regions from 1.85 percent at present but to remain slightly behind pre-COVID-19 levels of 2.35 percent.
Markets to remain supported by a decelerating but still positive earnings outlook for 2022, from 15 percent in 2020-2021 to around half of that, at 7.5 percent EPS growth, in 2022.
What do higher interest rates and inflation mean for investing
The market is now pricing in at least three to four interest rate hikes in the US with the first hike likely in March.
Energy and Financials were the market darlings of the recent rally in Value & Cyclicals. This was predicated on the back of potentially higher rates (good for banks’ profits), higher inflation (Energy is viewed as a hedge against inflation) as well as demand/supply imbalances in the case of Energy. Whilst the jury is still out, we believe this reversion to the mean (sell COVID-19 winners – IT and Healthcare and buy COVID-19-losers) is not something new and might continue with starts and stops this year. We have seen this rotation when vaccines were first announced in November 2020 as well as in Q1 2021.
On the Energy front, US and China (and later India) have coordinated to release some of their oil reserves back in late November which brought the oil price down to around $71 in mid-December from a high of $81 in November. This sends a strong message to the markets. EIA expects OPEC production to increase by 2.7M barrels per day in 2022 which could reduce pressure on oil prices this year. The Russia-Ukraine conflict has sent oil prices spiking however we have seen Western countries such as the US committed to the release of oil reserves to steady the markets.
Financials had a mixed Q4 reporting season in the US which is 60 percent of the Index. In 2022, the market is expecting Financials earnings to fall -8.9 percent yoy. The big global banks earnings are estimated to contract 15 percent over the same period driven by stagnant loan growth and higher expenses due to compensation and spending on marketing and technology.
Findex Tactical Asset Allocation (TAA) Position
Findex portfolios remain overweight in Growth Assets with overweight positions in International Equities, Hedge Funds, Australian Real Estate Investment Trust’s (AREITs) and Domestic Floating Rate. Underweight positions are held in Domestic and International Fixed Income and International Property. This positioning continues to hold our portfolios in good stead as illustrated in the performance graph above.
The timing and impact of geopolitical events are difficult to anticipate and introduce a higher level of uncertainty to markets. With rates expected to rise this year and in 2023, we expect a volatile environment ahead.
Valuations and earnings will come in focus as the market incorporates higher rates into their stock price modelling. We believe good active management to be key in the period ahead as we navigate through this period.
In an investment environment of low returns, working with a team of experts, who each have their own area of deep specialisation, is in the best interests of any investor looking to generate genuine returns over the long-term.
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7 March 2022
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