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 modestly lower. This is consistent with their response to previous similar events that we outlined in articles on the conflict published on January 31, February 22 and February 24.
Market reaction to geopolitical events involving Russia since the fall of the USSR
*Turkey is a member of NATO, now and at the time of the event.
Source: Charles Schwab & Co., Inc. and FactSet. Data retrieved 2/24/2022. All price performance is in USD.
Past performance is no guarantee of future results.
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.
Chinese aircraft entering Taiwan’s air defense zone are a near-daily occurrence
Source: Charles Schwab, Ministry of National Defense of ROC (Taiwan) data as of 2/25/2022.
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. As you can see below, the spread between Brent and West Texas Intermediate (WTI), the U.S. oil benchmark, has spiked, reflecting the invasion's greater impact on global energy prices.
The price difference between Brent and WTI oil prices has widened
Source: Charles Schwab, Bloomberg, as of 2/24/2022.
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, below is a visual from the Atlas of Economic Complexity showing Russia’s exports as of 2019. As you can see, it’s a “red sea” in terms of energy-related exports, with a heavy bias toward oil.
Energy-related products are a big portion of Russia's exports
Source: The Observatory of Economic Complexity (OEC), Mauldin Economics. Colors depict different types of exports: reddish brown = mineral products; bronze = metals; dark pink = chemical products; purple = precious metals; dark blue = machines; bright yellow = vegetable products; red = wood products; light blue = transportation; lime green: foodstuffs; light pink = plastics and rubbers; tan = animal products; pale yellow = paper goods; gold = animal and vegetable bi-products; dark purple = instruments; orange = stone and glass; dark green = textiles; silver = miscellaneous; gray = art and paintings; dark green = footwear and headwear; mint = animal hides; pale mint = weapons.
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.
Most of Russia's exports go to Europe and Asia
Source: The Observatory of Economic Complexity (OEC), Mauldin Economics. Colors represent various geographical areas: purple = Europe; red = Asia; blue = North America; yellow = Africa; green = South America; orange = Oceania.
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, 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.
Market pricing of steady Fed rate hikes changed very little in response to the Russia-Ukraine conflict
Source: Bloomberg. Market estimate of the Fed funds using Eurodollar futures (EDSF). As of 2/25/2022.
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.
Bloomberg U.S. Financial Conditions have fallen below zero, indicating tighter lending conditions
Note: The Bloomberg U.S. Financial Conditions Index tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.
Source: Bloomberg. Bloomberg U.S. Financial Conditions Index (BFCIUS Index), daily data as of 2/25/2022.
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.
Ten-year yield still has room to rise
Source: Bloomberg. U.S. Generic 10-year Treasury Yield (USGG10YR INDEX). Daily data as of 2/25/2022.
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. Use the Portfolio Checkup Calendar to schedule your consultation to identify areas of your portfolio that may have drifted away from their target asset allocation.
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