Special Market Update

February 15, 2022

Rising geopolitical tensions on the back of Russian aggression

What’s Important

• Worrying developments over the weekend have made Russian military action against Ukraine a much more likely outcome in the near term.

• While markets have started to price in a greater likelihood that Russia will invade Ukraine, a Russian invasion is not fully priced in. We would expect much higher volatility across markets and haven trades to benefit until there is greater clarity on Russia’s intentions.

• Even if no further military action occurs, we expect longer-term implications to be higher energy and metals prices, and ensuing slower global growth.

• Despite the rising risks of a political and energy-driven slowing in global growth, the fundamentals for most equity markets remain intact.

• Portfolios should be near long-term allocations. Look for opportunities to add to equities and to commodity exposure on event-driven pullbacks. 

Amid Russian denials, news headlines continue to spin wildly. Despite the spin, we believe the primary issue driving Russia’s recent actions is its long-stated desire to have Ukraine not be a part of the North Atlantic Treaty Organization (NATO). As in Georgia, Russia’s invasion of eastern Ukraine may be the “red line” for NATO regarding Ukraine’s joining. Nonetheless, recent diplomatic attempts to de-escalate the situation and move Russian troops away from the Ukrainian border have not succeeded, and concern in the United States and Europe continues to grow. 

For investors, we believe that the base case should be ongoing Russian aggression towards Ukraine and rising risks of an invasion.

1. Diplomatic actions have done little to curb Russia’s buildup of military capabilities at the Ukrainian border. Russia has largely ignored western attempts for a middle-of-the-road solution, despite being offered diplomatic off-ramps. Recent calls between Biden and Putin, and Macron and Putin produced nothing tangible.
2. Russia’s military buildup continues to add troops to the Ukraine border, and Russia continues to conduct exercises in the eastern Ukrainian separatist regions. Russia has also made a show of force through a huge naval presence in the Black Sea.
3. U.S. intelligence suggests an invasion is imminent, as evidenced by the decision to evacuate the embassy in Kyiv over the weekend. 

We believe investors should view the aggression toward Ukraine as part of a long-term, ongoing situation that will continue to add volatility to markets. Russian aggression against Ukraine could take several forms, such as a full-scale invasion or support for separatist parties or covert actions, and this could go on for quite some time. While most geopolitical events are forgotten quickly by financial markets, the issues at stake have clear implications for energy prices in the short term. We would also expect there to be major long-term implications for economic and financial markets should energy prices remain at high levels — by pricing in a political risk premium.

• We believe markets have not priced in the full extent of the implications of Russia invading Ukraine. While equity markets have retreated on fears, we think recent trading price action is not a reliable signal. We believe more volatility is still ahead as markets reevaluate the macroeconomic and financial risks of further escalation, specifically the likely higher cost of energy prices. 
• A Russian invasion of Ukraine resulting in sustained high energy prices or more restrictive sanctions on Russia as a retaliation through withholding energy from Europe could add as much as 2%-points to inflation in developed markets, particularly across Europe according to Capital Economics. Given the current inflation backdrop and hawkish rhetoric from developed central banks, the current loose monetary policy would need more tightening as a result. On the fiscal side, we have no expectations for policy response given the current political climate in the U.S.

If Russia does invade Ukraine, we believe the U.S. sanctions will be commensurate with the scale of Russian actions. We would expect to see financial sanctions targeting Russian financial institutions, including the exclusion of Russia from the SWIFT international payments system. Penalties would also include further restrictions on the trading by U.S. citizen of Russian debt, and restrictions on exports to Russia of sensitive technologies. We would expect oil and gas prices along with haven assets like gold, the Swiss Franc and U.S. Treasuries to spike higher, while risk assets see much higher levels of volatility.

Beyond the infinite what-ifs investors can imagine, we still see corporate fundamentals as largely intact; and given recent producer price data, we remain confident in our profit-growth story for 2022. The aforementioned ongoing political issues are set to make the Fed’s job harder in 2022; and we now expect at least six rate hikes for 2022 on the back of stronger-than-expected inflation data and a higher geopolitical risk premium built into energy prices. Despite the expected volatility, we think investors should not be too far away from their long-term asset allocation targets. Strong fundamentals and negative real yields on cash and bonds are a good argument to use volatility to rebalance and reposition portfolios toward higher-quality equity assets in the U.S. and Europe, and toward higher commodities exposure.

• February 15: German Chancellor Olaf Scholz’s visit to Ukraine and Russia
• February 20: Russia’s planned conclusion of military exercises with Belarus