With the caveat that short term prediction in volatile markets is generally a fool’s errand, we thought it might be helpful to provide a few comments on markets following the news that the tensions between Russia and Ukraine have, today, escalated into an invasion of Ukraine by Russian troops.
The invasion had been widely expected and to some extent factored into market prices which tend to be forward looking, however most markets have still registered some surprise at the speed of escalation, opening lower today by between 1-3%. Developed markets are now at roughly the same levels as they were this time last year. Most commentators are of the view that this will remain a localised conflict with little appetite from the US and European Governments for a ground war with Russia – as such, the broader conflict is likely to be fought economically through sanctions with Russia but also via diplomatic efforts to shore up relationships with other countries e.g. Iran and China.
We have been uncomfortable with the political uncertainty around Russia and the Eastern European markets for some time so have little or no direct exposure to the region in client portfolios, although a number of Russian Companies are listed on the London Stock Exchange so there will be a small amount of indirect exposure through UK index funds and global emerging markets funds.
In terms of direct economic impact, it might be helpful to provide some context: Russia is not a major importer from a Western trade point of view: outbound trade in goods with Russia from the EU is below 2% of total exports, but Russia is a major supplier of Oil and Natural Gas with exports of c.$240bn per annum or 15% of Russian GDP mainly to Europe. Ukraine’s economy is more agricultural and in combination with Russia’s agricultural exports provides about 25-30% of the global wheat supply. In short, the actual long-term effect on Western economies and trade, if the conflict is contained to Ukraine, but harsher sanctions are imposed, is probably relatively small. However, it is likely to have knock-on effects on both inflation and risk sentiment in the short term.
These second order effects, and reason for much of the uncertainty in markets today, is the effect that this conflict will have on inflation. Inflation had already been rising more sharply than most commentators and certainly the central banks had predicted last year, in part due to supply chain bottle-necks as economies reopen at different paces post Covid. We are sure you do not need reminding energy prices have also been a major contributor to the rising cost of living with both petrol and household energy prices having already risen sharply over recent months. The Oil price hit $80 per barrel at the beginning of the year and now hovering around the $100 pb mark with projections that it could hit $120-140 pb as a result of this conflict. This could add as much as 2% to (already high) global inflation numbers. Food price inflation may also rise on concerns over Russian/Ukrainian wheat supplies most of which are shipped from the Black Sea ports – geographically at the center of the current conflict.
The expected response to inflation is for central banks to raise interest rates. Markets have been expecting a sequence of interest rate rises in the UK and US this year as the normal policy response. However, the jury is out as to whether even higher inflation driven by energy prices will increase the hawkish resolve of policy makers to raise rates, or if rate rises may now be more muted or postponed until there is greater clarity and less volatility in markets. Raising rates would increase debt and mortgage costs squeezing already stretched family incomes so might not be the logical policy leaver to use given that, at this stage, inflation seems to be driven by rising input costs rather than excessive consumer spending. As is sometimes quoted in commodity and energy markets: “higher prices are the best cure for higher prices”.
In the short term defensive assets such as Gold, US Government Bonds, defensive Absolute Return funds and Quality/Value Equities are likely to be the best places to hide in this environment, but at a portfolio level we think it is still sensible to look through the noise and reconcile ourselves to the fact that we are investing for the long term. We build well diversified portfolios precisely because global shocks occur with surprising regularity. We expect volatility to continue as the market digests the implications of this conflict but at the margin, for those with surplus cash, this may be an opportunity to invest in markets and funds at more attractive levels than has been possible recently.
TT 24.02.22
This note is intended to be a general market update and should not be construed as a recommendation to invest in any particular fund or asset class. If you would like to discuss the implications for your own portfolio please feel free to ring or email us.