Markets Rattle as Russia Attacks Ukraine
The conflict between Ukraine and Russia has intensified considerably over the past week. Once the Russian invasion began, it quickly became clear that the hostilities would engulf the entirety of Ukraine, extending well beyond the Donbas region and the conflict there that Russia cited as a pretense for action. As events have rapidly unfolded, serious concerns have arisen about Russia’s ultimate goal and how far President Vladimir Putin may be willing to go to achieve those goals.
At times such as these, our thoughts go first to the people of the region, where many lives will be lost, millions will be displaced and countless more will be severely impacted as the full weight of this war becomes clearer in the days ahead. The humanitarian crisis within Ukraine is real and growing. An estimated one million Ukrainians have already flooded across the border into Poland and its European neighbors. That’s still a small percentage of Ukraine’s 44 million residents, and countless more will undoubtedly follow, creating a significant refugee crisis for Europe to absorb. Whether in lives lost or otherwise permanently changed, we’re reminded again that the primary cost of war isn’t measured in dollars but by the human toll.
Still, we recognize our role is to speak to our clients and investors more broadly about what this means for the capital markets, which have experienced further volatility in recent weeks. While we watch these developments alongside you, we acknowledge the significant uncertainty around the geopolitical environment. In short, we can’t predict how events will unfold. What we can do is provide perspective about what these events mean for the global economy, for policy and for the capital markets.
We’ll first speak to the impact on the capital markets, where the immediate effects are most clearly seen and felt. Unsurprisingly, the buildup of tensions was already weighing on global equity markets as fears of a full-scale Russian invasion grew and investor sentiment deteriorated. This geopolitical crisis comes at a time in which risk assets were already under pressure in response to growing expectations for a more aggressive Fed response to inflation risk.
Geopolitical instability and the threat of war always produces an unambiguous negative sentiment, although its impact can vary widely across different markets, regions and investments. It inherently creates a source of significant uncertainty, acknowledging that once a conflict commences, it’s impossible to know how it will play out or how unintended consequences could exacerbate conditions. As in past events, the immediate reaction has been for equities and other risk assets to tumble as investors, at least at the margins, favor safety over growth potential in the near term.
Having been under pressure for several months as yields rose in anticipation of near-term Fed interest rate hikes and quantitative tightening, Treasuries have reversed course, with yields declining in line with the flight to quality. In recent days, the 10-year Treasury yield has dipped below 1.7 percent from its recent high above 2 percent. The U.S. dollar has strengthened moderately, and gold has edged higher over the past month as geopolitical tensions were building.
Oil prices have now risen by about 25 percent since January 31 and nearly 50 percent since the beginning of the year, with Brent crude surging above $110 per barrel. Higher energy prices have lifted the commodity complex but will also have direct effects on inflation expectations, which we will address subsequently herein. Agricultural commodity prices have risen sharply in response to the likely disruption of wheat and other exports from Ukraine. Sanctions imposed by the United States, the EU and their allies on Russia—and the potential for additional supply challenges—have lifted energy and industrial metals prices.
Equity markets have been volatile in recent weeks, although the U.S. market has held up better than might have been anticipated against such a tense geopolitical backdrop. That’s explainable, at least in part, by the rapid recalibration of expectations related to Fed policy. Expectations for interest rate hikes have been dialed back considerably in recent weeks, despite the growing probability that elevated inflation will be a factor for even longer as a result of the conflict. The combination of diminished expectations for short-term rate hikes this year and downward pressure on long-term yields have provided a counterbalance to heightened risk, allowing U.S. stocks to tread water. Global markets have diverged to a greater degree. Unsurprisingly, the Russian stock market crashed before being closed; to this point, it’s yet to reopen, but additional volatility is expected when it eventually does.
There have been indications that tensions could certainly escalate further. There’s simply no way to predict what will transpire in the fog of war. We should also acknowledge that there is still a tremendous amount of cash on the sidelines, some of which could continue to make its way into equities, supporting prices. We believe that investors should be prepared for the potential that volatility could continue for some period as markets weigh developments and attempt to recalibrate expectations accordingly.
The economic impact of these developments will almost certainly be as diverse as today’s wide range of performance in global stock markets, with the greatest negative fallout likely borne by Russia and Ukraine. Europe’s economy could also be more directly impacted than other developed economies given its close proximity to the conflict itself, its greater reliance on Russian oil and natural gas and its greater economic ties to the region.
The direct effects on the U.S. economy are likely to be comparatively muted as neither Russia nor Ukraine represent major trade partners. In 2021, U.S. exports to Russia ($6.4 billion) and Ukraine ($2.5 billion) ranked 39th and 59th—and comprised a small fraction of the $208 billion of total U.S. exports. Conversely, Russia benefited from nearly $31 billion of exports to the United States last year, largely concentrated in energy commodities, metals and other commodities. Additionally, it’s worth noting that Ukraine’s economy is relatively small at about $155 billion in 2021. (For context, that’s comparable to the economy of Washington, D.C. or Nebraska.) On a global scale, it accounts for about 0.14 percent of the global GDP. A war could devastate the region, but the global economic impact of even a protracted conflict is likely to be limited.
If there is a concern about the economic impact of these events, it’s clearly borne from rising commodity prices in recent weeks. As noted earlier, Brent crude oil breached $100 per barrel—the first time that threshold had been reached since 2014, ironically in the aftermath of the Russian annexation of Crimea. As a result, oil prices plummeted by more than half as a boom in U.S. shale production, some easing in geopolitical tensions and increased OPEC production provided relief. It’s far too soon to predict how much higher oil prices could rise or how long prices could remain elevated. Much will hinge on the scope and duration of the conflict, the impact of sanctions that have already been levied, the significant potential for additional punitive steps and the ability and willingness of other producers to increase output.
The question is what effect higher commodity prices will have on inflation at a time in which concerns are already heightened. It’s important to note that a temporary spike in commodity costs has limited impact on growth, but a more sustained increase over an extended period would become a greater headwind. While estimates vary, in general terms, economists believe that a sustained $10 increase in the price of a barrel of oil would trim 0.1 to 0.2 percent off the U.S. GDP. It could have a slightly more pronounced impact in Europe given its greater reliance upon imported oil and natural gas to meet its energy needs.
Directionally, this poses a risk that inflation pressures could remain elevated for longer than had been forecast, but at this point, expectations for those pressures to ease gradually over the coming year don’t materially change.
For now, the risk to U.S. expansion appears to be limited. As the recent report on Q4 GDP confirmed, the economy grew at a brisk 7 percent pace late last year. It would take a significant slowdown to put the expansion at risk. While a slowdown is likely, consumer demand remains strong in spite of rising prices. As the primary engine of the U.S. economy, we believe that consumers remain well positioned to push through the inflation headwind and act as a key catalyst to extend the expansion.
Monetary Policy Impact
That brings us to the Fed and the near-term outlook for monetary policy. Given what we know today, it seems unlikely that these events will prompt the Fed to materially alter its planned path. Since the beginning of the year, many economists had been aggressively ratcheting up their forecasts for the number of policy rate hikes by the end of the year, with some of those projections easily outdistancing the Fed’s most recent forecasts.
If anything, these events have dampened those expectations, bringing them closer to the Fed’s own forecasts. The question that policymakers will ultimately be grappling with is the degree to which these events create an additional catalyst to sustain high inflation versus their potential to hinder growth. Both are risks. Current domestic economic conditions (high inflation, above-trend growth and tight labor markets) point clearly to the need for the Fed to tighten policy via rate increases and winding down their bond purchase program. At the same time, global developments can’t be ignored. Policymakers will want to be careful to avoid tightening too aggressively if global conditions were to continue to deteriorate, creating greater risk to the global expansion.
The Fed will weigh all of these factors carefully in an attempt to strike a delicate balance in the execution of policy and their communication of future guidance. For now, we expect that policymakers will be undeterred, likely announcing a quarter-point rate hike in mid-March, while providing reassurance that they remain focused on data and developments, standing ready to adjust as needed should changing conditions warrant doing so. It seems unlikely that the escalation of the conflict in Ukraine would cause the Fed to pause, nor would the recent surge in oil prices seemingly be sufficient to cause the Fed to move to a 50 basis points increase in March, which would represent an acceleration of its stated tightening plans. In his most recent comments, Fed Chair Jerome Powell has effectively reaffirmed this stance.
Given the potential impact of this turmoil to both inflation and growth, which is the greater concern? If it’s inflation, the Fed will continue to hike rates as planned and potentially even consider some acceleration in their tightening plans as the year progresses. If a greater global growth scare develops, they may need to slow down their tightening pace. That balance puts the Fed between a rock and a hard place. But they are unlikely to adjust their response as a result of a spike in oil prices alone. An extended period of higher energy prices would require deeper introspection given the additional upward pressure on inflation and the effective sapping of consumer spending power as a form of tax on household discretionary income. The Powell-led Fed has thus far demonstrated a cautious approach and a hesitancy to act aggressively to tighten. Whether they will maintain that bias remains to be seen.
The bottom line? For now, it still appears to be a foregone conclusion that the Fed will maintain its tightening stance. It’s not a question of if or, even when, but how quickly and how aggressively the Fed will act.
When conditions are particularly uncertain, investors should focus on the known rather than attempting to actively trade or make major strategy changes based on “what ifs.” As always, we advise investors to confirm their need for liquidity and replenish their cash reserve, if necessary, to meet any near-term obligations. Maintaining broad portfolio diversification also helps to mitigate potential downside from risk assets, while preserving exposure to stocks and other risk assets that can reverse course quickly as conditions stabilize and investor sentiment begins to turn positive again. Today’s sharp reversal in the U.S. markets illustrates that point once again.
It’s also critically important to not lose sight of your investment time horizon. With sufficient cash to meet near-term needs, allowing your portfolio to remain invested while making targeted adjustments via rebalancing remains advisable.
Jim Baird is a CPA, CFP®, CIMA®, CIO and partner at Plante Moran Financial Advisors. Tricia Newcomb is a CIMA®, senior strategy analyst and relationship manager at Plante Moran Financial Advisors.