Macro views
Macro views

Russia/Ukraine conflict: A sustained market impact?

February 24, 2022 | 7 min read
Seema Shah
Chief Global Strategist
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After weeks of build-up and intelligence warnings, Russia launched a full-scale invasion of Ukraine, unleashing what may end up being the largest European conflict since World War II. The United States, Europe and NATO allies have condemned the move and responded with economic sanctions. While U.S. sanctions have so far been limited, given the escalation in Russian actions, there will inevitably be a more strident western response in the coming days. European sanctions, on the other hand, have been more forceful, with Germany stopping approval of the Nord Stream 2 pipeline, which would have carried Russian natural gas into Europe.

Although difficult, during a rapidly developing geopolitical conflict, investors are best suited to stay level-headed, considering that fundamentals are ultimately the driver of long-term investment returns.

A tough start to 2022

The escalation in the conflict has seen risk markets retrench further, with sharp falls in global equity markets and a widening in credit spreads. Broadly, commodity prices have risen, with Brent crude oil prices pushing above $100 per barrel for the first time since 2014. Ten-year U.S. Treasury yields, which just a week ago had broken above 2%, have fallen below 1.9% as investors retreat to safe-haven assets.

With the S&P 500 now in correction territory, this has been the second worst start to the year for U.S. equities since 2000. Yet, these moves are not solely (or even mostly) driven by the Russia/Ukraine tensions:

  • Equity declines began in January and were, at least initially, driven by inflation concerns and expectations for significantly sharper central bank tightening.
  • Energy prices had been rising steadily throughout the pandemic recovery and in response to lower-than-expected OPEC+ production.
  • Concerns around Federal Reserve (Fed) balance sheet reduction caused credit spreads to start to gap out in early January.

The Russia/Ukraine situation is certainly significant—but it has simply compounded these already challenging market conditions.

Global oil prices
WTI and Brent Crude, oil price in USD, January 2000 – present

Line graph showing global oil prices from 2000 to 2022, rising after 2020

Clearnomics, Principal Global Investors. Data as of 2:00pm ET, February 24, 2022.

The geopolitical conflict playbook

By their very nature, geopolitical developments are fluid and so it will be difficult to predict exactly how the conflict in Ukraine will play out over the coming days, weeks and months. Past geopolitical shocks, however, can provide investors with a sense as to how markets typically respond, and the duration of that response.

Over the last 60 years, geopolitical events have often been short-lived and have rarely had a sustained significant impact on equities. The median sell-off has been around 7%, typically taking around three weeks to reach a bottom and an additional three weeks to recover prior levels. What’s more, after three months, the market was on average, 4% higher. Steady positive economic growth, corporate performance, monetary policy and valuations matter much more than short-term market uncertainty so, in the longer run, it’s the underlying economic backdrop that will dominate market trends. 

When central banks have responded to rising oil prices by tightening monetary policy, the equity market sell-off has been more prolonged. During the oil embargo of 1973, for example, the Federal Reserve (Fed) hiked interest rates aggressively to counter the inflationary impact. As a result, bond yields soared and the subsequent equity market selloff took several years to recover.

By contrast, during the two Gulf wars, the Fed refrained from tightening monetary policy and the economic backdrop remained solid. Although equities sold off sharply, within nine months, markets had fully recovered and even gained meaningfully. It’s also worth acknowledging that during the 2014 episode in Crimea, there was little direct impact on oil prices. Similarly, the 2019 drone strikes against Saudi Aramco by Iran and others, which knocked out 5% of global oil production overnight, saw only a shortlived reaction in oil markets. Thus, the more medium-term direction of energy prices can be difficult to predict.

Market reaction to geopolitical crises
S&P 500 performance in past geopolitical shocks

Table displaying the market reaction to past geopolitical crises, with the 1973 Arab-Israeli War having the longest impact at a 19% downturn 180 days after the start of the conflict

Bloomberg, Principal Global Investors. *Peak level around key dates. Data as of February 23, 2022.

Underlying macro strength, but with risks

As with past geopolitical episodes, the economic and market context, and central bank response, hold the key to what investors should expect. Consider:

  • Current Russia/Ukraine tensions are taking place while risk assets valuations are particularly expensive, rendering markets vulnerable to geopolitical developments and, therefore, potentially exacerbating volatility.
  • Investors are preparing for the Fed’s imminent rate liftoff as it attempts to get back ahead of the inflation curve.
  • The underlying U.S. economy remains strong, supported by resilient consumers, solid corporate profits and healthy balance sheets.

While concerns are reasonable, and the U.S. economy could struggle if the Fed had to tighten monetary policy beyond the six hikes that the market is currently pricing in, economic fundamentals, and the strength of corporate balance sheets are more important for long-term investors than any geopolitical shocks.

A heightened central bank dilemma

Modern day central banks would ordinarily “look though” energy inflation driven by geopolitical shocks. However, with inflation already running so high and growing concerns around wage price dynamics, investors are concerned that there will be considerable pressure on central banks to tighten policy more aggressively.

For policymakers, it becomes a matter of prioritization, and it is likely that they will refocus on the risks to growth, rather than the risks to inflation in the short-term. That is not to say that central banks will postpone policy tightening until uncertainty fades, rather the Federal Reserve and other central banks are unlikely to be shifted from their planned policy tightening path.

Ultimately, the long-term path for risk assets will remain broadly unaltered: a modest path higher—but one that could be hit with significant volatility and uncertainty.

Personal consumption expenditures (PCE) inflation
Year-over-year change, 1960 - present

Line graph showing the year over year change in personal consumption expenditures inflation from 1960 to 2021

Clearnomics, U.S. Bureau of Economic Research, Principal Global Investors. Data as of December 31, 2021.

Investors: stay level-headed

History shows that it has been a mistake to make dramatic shifts in portfolios in response to geopolitical crises. Properly diversified portfolios are designed to handle these periods of uncertainty.

U.S. and global economic growth remain stable and although a sustained rise in oil prices would weigh on economic growth, the impact should be tempered by continued consumer resilience and healthy household and corporate balance sheets. At the same time, central banks are unlikely to shift their focus or accelerate tightening in response to the geopolitical conflict.

Thus, while near-term market movements may be choppy and further losses are possible, the constructive macro backdrop should, in time, stabilize conditions. Investors would be well suited to stay invested, but with a focus on factors that should remain relatively resilient through the near-term volatility.

Energy:
After years of underperformance, the energy sector will likely outperform as both a geopolitical and inflation hedge, rising each time the conflict escalates. Furthermore, given the structural supply shortage facing the industry over the coming years, energy could perform strongly regardless of the developments around Russia/Ukraine.

Quality:
The story remains the same—market conditions are inevitably becoming more challenging and geopolitical risks, coupled with inflationary pressures, mean that companies with robust balance sheets, strong business models and pricing power will be the beneficiaries.

U.S. over Europe:
Although the trade impact on the both the U.S. and Europe will be limited (Russia accounts for less than 1% of their exports), Europe is significantly more exposed to any energy disruption. As a net energy exporter, the U.S. is less vulnerable to a rise in oil and gas prices. Europe, however, is a net importer—over 40% of EU gas and 20% of EU oil originates from Russia. Any disruption of the supply of oil and/or gas will have a significant impact on energy prices across Europe and, therefore, on growth and inflation, leading to a preference for U.S. based investments.

Disclosure

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