By Jeffrey Kleintop, Kathy Jones and Liz Ann Sonders, Charles Schwab
The world is watching anxiously as the Russian military moves deeper into Ukraine, expanding an invasion that began Wednesday night. Although the human cost of military action is incalculable, global stock markets in general reacted to the invasion with wide swings before closing higher for the week.
The potential for global economic disruption from an invasion was most likely to come from sanctions. The chaos on the ground in Ukraine contrasts with the clarity on sanctions. As expected, the United States and the European Union announced a new tougher round of sanctions on Russia on Thursday in response to the invasion, with other major global economies following suit.
These sanctions are designed to hurt Russia’s economy without affecting global energy and agricultural supplies in a way that could inflict a “stagflationary” shock (the combination of high inflation and low growth) on the rest of the world.
At this time, U.S. and EU leaders are not targeting Russian energy exports and Russia is not threatening to cut off oil and gas shipments in retaliation to the sanctions. Because energy makes up 60% of Russian exports and 30% of its gross domestic product, Russia may be more inclined to reap the windfall from high prices than to deny itself critical revenue at a time when its economy is at risk of recession.
Avoiding impediments to Russia’s ability to sell oil significantly weakens the impact of sanctions, but also reduces the risk of major worldwide economic disruptions. This contributed to the muted market reaction.
Russia and Ukraine are relatively small countries from an economic and supply chain perspective, excepting a few commodities. By contrast, a potential Chinese invasion of Taiwan would involve large economies that play a critical role in a wide variety of global supply chains.
Stoking fears early Thursday were reports that nine Chinese military aircraft entered Taiwan airspace, with some suggestion that China was taking advantage of a distracted NATO. However, these overflights happen every day, according to Taiwan’s Ministry of Defense, as you can see below.
Investors should not become single-mindedly focused on the conflict in Ukraine and take their eyes off economic indicators. Prior to these recent geopolitical events, the European economy reported a much better-than-expected rebound from the COVID-19 omicron variant.
For example, the preliminary reading of the composite purchasing managers index (PMI) climbed to its highest level in six months in February. Although this conflict may contribute to existing inflationary pressure and tighter lending conditions, the potential drag to growth comes at a time when economic momentum was rebounding.
U.S. stocks: A sustained oil-price jump could pressure stocks
The price of Brent crude oil jumped to more than $100 per barrel on Thursday, and will likely remain elevated while markets assess potential supply disruptions and the availability of alternate oil supplies. Brent crude is produced from the North Sea between the UK and Norway, and is a global oil price benchmark.
Although unlikely near-term, the risk of a U.S. recession already existed, given tightening financial conditions and pending Federal Reserve short-term interest rate hikes, which are likely to begin in March. Sustained high energy prices would worsen concerns about slowing economic growth.
In terms of the sanctions’ direct impact of disruptions to Russia’s economy, based upon 2019 data, a large percentage of Russia’s exports are energy-related, with a heavy bias toward oil.
The countries that import Russia’s exports are concentrated in Europe and Asia. The United States represented less than 4% of Russia’s exports in 2019.
On paper, the United States may not directly pay a significant price from sanctions being imposed on Russia, but some investors — particularly hedge funds — could be hurt via their holdings of Russian debt. That said, we are not likely at risk of a repeat of the late-1990s Russian debt default, which led to the spectacular collapse of Long Term Capital Management.
Despite the sharp reversal in the market Thursday and Friday, stocks probably will remain volatile and subject to headline risk in the weeks to come. What is likely to remain consistent is investors’ preference for stocks of higher-quality companies, those with factors such as strong free cash flow yield, strong balance sheets, and positive earnings revisions.
As central banks begin to tighten monetary policy — now coupled with increased geopolitical uncertainty — we believe the low-quality, highly speculative stocks that performed well early last year will not move back into vogue.
Fixed income: Outlook for Fed policy is less certain now
Since the news of the Russia-Ukraine conflict hit, the U.S. bond market has been on a roller-coaster ride. Initially, U.S. Treasury bonds rallied as investors sought safe-haven assets. However, the initial drop in yields was largely reversed in the subsequent 24 hours.
Ten-year Treasury yields plunged from nearly 2% to as low as 1.82%, before rebounding in the space of two days. Similarly, the market’s pricing of the path of Federal Reserve policy has changed very little, despite the heightened uncertainty about the impact of economic sanctions on growth and inflation prospects.
However, we believe that the outlook for Fed policy is far less certain now than prior to the outbreak of the conflict in Ukraine. On the one hand, inflation is likely to remain high or move higher due to the shock from the reduced supply of commodities to the global market.
Energy and grain prices, which were already rising sharply, could rise even faster, resulting in higher headline inflation — however, given that sanctions so far aren’t targeting the energy and agricultural markets, we don’t necessarily expect this to happen. However, commodity price shocks often reduce demand and slow growth longer term.
In addition, financial conditions have tightened substantially over the past few months as global central banks signaled tighter policies, and risk premia have been rising. In Europe, yield spreads between German and peripheral government bonds have been widening, and domestically, riskier assets have declined in value. If central banks move too rapidly to tighten policy, it could trigger even more tightening in financial conditions.
We still expect the Fed to hike the federal funds rate by 25 basis points at the March meeting, barring a major change in the outlook, as inflation remains its primary concern. Longer-term, the Fed will have to weigh the outlook for ongoing high inflation against the potential for slower growth. The result could be a slower path to raising rates than currently anticipated.
Intermediate to long-term bond yields are likely to be volatile, reflecting the cross currents in the economic outlook. We still see room for 10-year Treasury yields to rise if tensions ease. However, the path of long-term rates are tied to prospects for long-term growth.
What investors can consider now
This week’s market reaction to the Ukraine invasion has generally tracked its reaction to prior Russia-related events, i.e., minor changes in market averages and limited economic impact. The takeaway for investors is to avoid getting caught up in dramatic events as they unfold, as it rarely leads to wise decisions. While staying the course and continuing to invest even when markets dip may be hard on your nerves, it can be healthier for your portfolio and can result in greater accumulated wealth over time.
These periods of volatility are also reminders of the benefits of the tried-and-true disciplines around diversification (across and within asset classes, including U.S. stocks, international stocks and high-quality bonds) and periodic rebalancing — all tied to each investor’s long-term strategic asset allocation strategy.
Over time, assets that have gained in value will account for more of your portfolio, while those that have declined will account for less. Rebalancing means selling positions that have become overweight in relation to the rest of your portfolio, and moving the proceeds to positions that have become underweight. It’s a good idea to do this at regular intervals.
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