Special Market Update

February 24, 2022

Russia-Ukraine Update

What’s Important

• Last evening, Russia’s full-scale assault on Ukraine marked the end of ambiguity with events now rapidly moving down a severely adverse path for global security.

• The assault is no longer confined to two Russia-backed separatists in the Donbas region. It goes without saying that the outcome is extremely uncertain.

• Our advice is to stay the course and remain invested with portfolios remaining in line with your long-term goals. Market timing is historically a losing game and selling during times of stress can have negative consequences for long-term returns. When markets find an equilibrium and rebound from lows, market upswings could be strong and remaining uninvested could hurt returns.

What happened overnight in Ukraine?

Last evening, Russia’s full-scale assault on Ukraine marked the end of ambiguity with events now rapidly moving down a severely adverse path for global security. The situation on the ground continues to evolve by the minute, but it’s clear that events overnight represent a major escalation in the conflict. The assault is no longer confined to two Russia-backed separatists in the Donbas region. It goes without saying that the outcome is extremely uncertain. At the far end of the spectrum, it’s still possible that the conflict could settle down quickly if Russia calls off air-strikes in Ukraine, having hit key military targets. In this scenario, Russia would retain control over the separatist regions but would withdraw troops from the rest of the country paving the way for an uneasy truce.

At the other end of the spectrum, the events overnight could be a precursor to a more fundamental redrawing of the map of Europe. This could telegraph a new and even more dangerous stage of the conflict if it draws in NATO members, including the Baltic states. A plausible middle-ground assumption is that there is a full-scale invasion of Ukraine that results in a change in its status and government. At this stage though, given the enormous uncertainty, we believe it best to think in terms of scenarios and then think through macro and market consequences rather than draw a line in the sand and try to forecast outcomes.

Market reaction

The immediate impact of Russia’s move in the Ukraine was a broad “risk off” flight to quality paired with a surge in commodity prices. Brent crude prices breached $105B, global equities sold off including a substantial 33% decline in the MOEX Russia Index, bonds gained while credit spreads widened, and both the U.S. dollar and Japanese yen gained more than 1% relative to the euro. In many respects the market reaction has been a culmination of trends already in place as simmering tensions led to this boil.

Equity implications

The Russian invasion of Ukraine is a net negative for equities in two dimensions: 1) Investors are likely to lower valuation premiums given elevated uncertainty, and 2) fundamentals could eventually become impaired if economic growth is blunted. With markets already on edge given the prospect of tighter-than-expected monetary policy, the attractiveness of riskier assets including stocks is diminished given additional uncertainty. Meanwhile, corporate earnings remain solid and a foundational component of our expectation for equities to continue their climb. However, higher commodity prices resulting from supply disruptions from Russia may both hamper the inflation-adjusted purchasing power of consumers while also challenging corporate margins.

We note that historically, geopolitical events have often led to quick equity downturns followed by sharp reversals and impressive performance in the months following. However, we urge caution that the past is not a perfect prologue, as it pertains to extrapolating the different contextual episodes of the past to the present. In our view, the macro backdrop remains supportive for growth and positive returns for equities but to a lesser degree than in quarters past. This incremental shift is a reflection of geopolitical headwinds and the expectation for monetary policy to tighten going forward.

From a positioning standpoint, we continue to advocate our preference toward quality and profitability. The most acutely exposed segments to the current conflict are Energy and Europe, in our view. Energy prices are likely to remain elevated due to the increased imbalances of supply and demand, while the European economy is more reliant upon imported Russian energy and global trading activity, which may be disrupted. We find that U.S. large cap equities benefit from the domestic economy’s relative energy independence along with an attractive blend of quality, growth and shareholder yield.

Fixed income implications

Given the conflict abroad and weakness in the equities market, there is a clear flight to quality within the fixed income space, benefitting U.S. Treasurys. The yield curve remains flat. Credit spreads continue to move wider with the current “risk off” sentiment. Investment grade spreads are up almost 30 bps year-to-date with high yield up closer to +60 bps. Higher energy prices primarily due to the Russia-Ukraine situation continues to pressure headline inflation. We will likely see 8%+ YOY prints over the next couple of months. Liquidity and volume in fixed income markets is lighter than usual reflecting the hesitancy for dealers to add risk to their balance sheets.

Early indications reflect that the Russia-Ukraine situation will not alter the Fed’s course of action, except perhaps to build more of a case for a 25 bps move instead of 50 bps right out of the gate in March. Depending on where and how long this situation goes on, it may force the Fed to move slower than expected a few weeks back (i.e., perhaps ending 2022 with only 100 bps or so of hikes instead of 150 bps). One thing is clear, the path remains higher for rates in 2022.

Our fixed income view remains unchanged. We continue to expect rates across the curve to move higher, led by shorter maturities, thereby flattening the curve. Credit fundamentals remain strong with credit spreads likely well contained ahead. We expect episodic market volatility driven by the geopolitical risks and central bank policy changes. Portfolio positioning remains short in duration with an eye on being opportunistic given the anticipation of a heightened rate backdrop.

Going forward

As this situation is quickly unfolding, we expect episodic volatility until there is some clarity on the situation in Ukraine. The breadth of the economic and market impact will depend on what type of sanctions are applied by the West. In our view, the most likely measures would further target Russian financial institutions, investments, trade, and energy. There is even the extreme possibility of barring Russia from the cross-border SWIFT network, however at this time U.S. and European officials have taken this option off the table. However, it is likely that Putin will retaliate, whether that is through a reduction of supply in the energy sector or potential cyberattacks.

The most dramatic impact from this assault and resulting sanctions will likely be in the energy markets. Russia is a major producer of oil and natural gas. Furthermore, it supplies the majority of natural gas to Europe. In the near term, energy prices will move higher as concerns about global security and energy supply will remain front of mind for markets.

With all the uncertainty today, it is important to remember that the U.S. economy is in a state of relative strength. Consumer balance sheets are healthy and corporate profits continue to grow. Over time these types of geopolitical events will find an equilibrium in markets. Whatever the path may be, we expect the world to move on from here. That said, we do expect some bumps along the way as markets don’t like uncertainty.

Our advice is to stay the course and remain invested with portfolios remaining in line with your long-term goals. Market timing is historically a losing game and selling during times of stress can have negative consequences for long-term returns. When markets find an equilibrium and rebound from lows, market upswings could be strong and remaining uninvested could hurt returns.