Market Flash
The arrival of the Russian army in Ukraine on 24 February 2022 shook minds, hearts and markets. What happens next remains unpredictable, as the conflict has complex global repercussions. No one knows how the presidents of Russia, Ukraine, the United States or China, in particular, will behave in the weeks to come.
So how should you react when you are an investor?
The impact on markets
What really happened on the markets? A European investor, closely affected by the events, may have the impression that the crisis has shaken the market. It is true that commodities, wheat, gas, electricity, metals, have soared and the barrel of oil has approached $130 compared to just over $70 at the beginning of the year.
The impact on equities is in fact measured. On the evening of 14 March, the Stoxx 600 Net Return – representing the majority of European capitalisations – had lost only 3.6% since the morning of 24 February. In the US, the S&P 500 (in dollars) was only down 1.2% over that period! But emerging equities lost more than 12% (in dollars), affected by Russian equities, but also by Chinese equities, which are facing other difficulties. However, few European investors are heavily invested in these markets.
On the bond market, performance is negative over the same period: between -1 and -2% on European credit (depending on its rating). Government bonds fell by barely 1%, after a substantial appreciation in the early days of the crisis.
The most obvious victim is the euro, which loses about 3% against the dollar. For a diversified investor, this is rather good news, as his dollar assets appreciate by the same amount. And European equities generally benefit from a weak euro.
While equity, credit and government bond markets have been clearly negative since the beginning of the year, most of these losses occurred before the Ukrainian crisis. Inflation was already present. Central banks were indicating a forthcoming monetary tightening. Highly valued equities were already under pressure due to monetary policies.
In summary, the Ukrainian crisis has so far not had a strong impact on most global markets. Central banks have done much more.
What prospects?
The path of the markets over the next few days is likely to be dictated by two main factors – although others may emerge unexpectedly at any time: the development of the Ukrainian conflict and central banks.
On the former, it would be presumptuous to predict with determination any outcome. While it is possible that the Russian army will gain further ground, a total and rapid Russian victory seems unrealistic. Stalemate, accompanied by chronic instability, while not very threatening on a global scale, is in our view more so.
Other scenarios, less likely in principle, are possible, such as a rapid Russian victory or, on the contrary, a retreat. In the first case, its superiority could fuel new Russian ambitions and generate new economic or even military retaliation by the West. In the second case, the Russian operations could become more violent, as the government would have to do everything in its power not to appear to be losing. Everything would then depend on the attitudes of the other giants of the planet. These two scenarios seem to us the least likely in the short term today, as they would be costly for all parties involved.
In what we believe is a more likely case of a form of stalemate, the main market drivers will once again be macroeconomic fundamentals, in particular inflation and growth, and the reaction of central banks to these factors.
Both aspects will depend in part on a key variable: the duration of the conflict. The longer the conflict lasts, the more commodities are likely to remain at high levels, which would support inflation and mechanically reduce growth. Central banks are therefore partly dependent on the duration of the conflict. The ECB has just incorporated the war into its forecasts, raising its inflation expectations[1] and lowering its growth expectations[2] . The Fed will do the same after its meeting on 16 March. No doubt it will do the same.
Because of this high inflation, both banks have planned to move, at different paces, towards gradual monetary tightening. This calls for caution in equities, especially highly valued ones; and total caution in government bonds, especially US ones, which are losing their main buyer of recent years – the Fed. The troubled geopolitical context and the resulting growth deficit will not necessarily prevent rates from rising.
In detail, the situation could be different between the US and Europe. While European inflation is mainly due to commodities and certain industrial materials, US inflation is also due to strong demand and housing prices. The reaction to the first type of inflation does not require a drastic tightening, because a central bank cannot do anything about the price of raw materials. The response to the second type of inflation, on the other hand, is within the reach of a central bank, which can curb inflation by slowing down credit formation. The Fed should do this. In this case, higher-valued stocks could be more affected than lower-valued ones, continuing the trend that has been underway for several months.
In terms of company results, a discrimination has already been made between companies and sectors that directly generate a large part of their turnover in Russia or Ukraine: banks or the European automotive sector have suffered more than the market. On the other hand, the rise in raw materials and the resulting increase in costs is still difficult to measure. In a persistent inflationary context, it is necessary to be discriminating and to focus on companies that are able to preserve their margins and thus pass on inflation to their sales prices.
In any case, caution is called for, especially as some scenarios should include the renewed strength of the Covid in China. In our view, this does not entail staying out of the markets altogether, unless the conflict escalates (which is unlikely). In a median scenario, inflation will eat away at the value of any non-risky asset. It is therefore reasonable to rely on the equity market in the medium term, despite its volatility. Particularly in active management, attentive to the valuation of securities. After all, equities have come out on top in every crisis. Only the chosen path is unpredictable.