War and inflation put bull market in hibernation

Shep Perkins, CFA, Chief Investment Officer, Equities, 03/15/22

To say Russia’s invasion of Ukraine has changed the outlook for financial markets is a vast understatement. Russia President Vladimir Putin’s aggressive attempt to erase Ukraine as a sovereign entity could have major implications for the global world order. While we all hope for a peaceful resolution to this humanitarian and geopolitical crisis, we must also consider the potential for less desirable consequences.

For financial markets, investors may be underestimating the immense range of potential outcomes for this conflict. It is extremely difficult to “price in” such a diverse set of scenarios. In fact, the current level of uncertainty is reminiscent of two years ago, with the arrival of the Covid-19 pandemic. As we said in March 2020, the world won’t be going back to the way it was just a few weeks ago.

An “economic world war”

The military conflict is currently contained to two countries, but for global markets, we could be entering an “economic world war.” One unique aspect of this Russia-Ukraine War is the widespread corporate self-sanctioning. We’re seeing so many multinational companies with world-renowned brands suspending operations in Russia. This is inflicting economic pain on Russian citizens, who have been consuming increasingly more foreign products and services since the collapse of the Soviet Union in the early 1990s.

Sanctions were quickly implemented on almost everything except essentials like oil, gas, and food. Russia is resource rich but manufacturing poor, exporting natural resources and importing goods. Russian-produced commodity prices are soaring. This includes everything from energy (oil, natural gas, coal) to food (wheat, corn, fertilizers) to metals (nickel, palladium). The world relies on this supply of commodities. Moreover, shipping challenges abound. Ports are blocked and vessels are lined up in record numbers, making an already fouled logistic situation worse.

As we said in March 2020, the world won’t be going back to the way it was just a few weeks ago.

Implications for a new world order

China appears to be making a move to fill some of the trade vacuum with Russia. China may be content to buy Russian resources at a global discount and sell Chinese goods back to Russia. If this comes to pass, China will be viewed as a clear rival, if not an enemy, of the West. Yet China will remain a necessary U.S. trading partner — an uncomfortable scenario.

New priorities for global economies

Europe needs to move away from its reliance on Russian energy. But this will require years of investment in gas, solar, wind, and other energy infrastructure. Europe has perennially underinvested in defense and will borrow considerably to ratchet up military spending and to subsidize food and energy costs.

In the U.S., the pressure to “re-shore” will only intensify as corporations reallocate investments away from China and back to domestic markets. The environmental mindset is likely to shift from “no carbon” to “carbon conscious + energy security.” This shift, in combination with higher energy prices, should be a tailwind for fossil fuels, which will fetch higher prices. But it should also benefit renewables, which will become more competitive because of the higher fossil fuel prices.

Investment implications

We are monitoring four compounding headwinds in the current environment.

Uncertainty. The multitude of possible outcomes to this war has created great uncertainty — a classic trigger of equity market volatility. Uncertainty has already resulted in a strengthening U.S. dollar, which is likely to be a headwind for U.S. corporate earnings. Uncertainty also puts downward pressure on the equity market’s price-to-earnings multiple.

Pressure on growth. Russia’s economy will shrink sharply, but GDP growth will also slow in Western economies, given the higher cost of everyday goods and acute shortages of manufactured goods. Less-wealthy consumers around the globe will be hit hardest as staples — food and energy — make up a larger portion of their budgets.

Inflation. Higher inflation is likely to be with us for longer than anticipated. In February, U.S. inflation matched the highs of the past 40 years, at 7.9%. There had been signs of easing in the labor force tightness, but this will be overwhelmed by spikes in food and energy prices, with further upward pressure due to shortages. At this time, the Federal Reserve and the European Central Bank remain committed to tightening. However, much of the inflationary pressure will be unaffected by any rise in short-term interest rates.

Confidence. For less-wealthy consumers, what lies ahead could feel like a global recession. But current conditions are likely to hurt consumer sentiment at all levels. Often, this leads to a pullback in consumer spending, especially on large discretionary purchases such as homes and autos.

A new world order may serve as the impetus for new infrastructure investment around the globe.

Markets adapt and opportunities emerge

The Russia-Ukraine War is a devastating humanitarian crisis. Much like the Covid-19 pandemic, it has quickly brought hardship, suffering, and a painful blow to global economies. We all hope it is a short-lived crisis with a peaceful resolution. And as equity investors, we are constantly monitoring the risks, assessing potential outcomes, and positioning our portfolios with a long-term perspective.

Providing an outlook is challenging as the situation remains highly fluid. Until we have more clarity on how it will unfold, high volatility is likely for equity markets. However, we believe it is important to remember the incredible resilience of the equity markets throughout history. Two years ago, many investors couldn’t imagine that markets would be able to withstand the sudden shock of Covid-19. While this war is a different type of crisis, its influence on the markets will likely diminish over time.

While it is too early to determine the timeline, financial markets do adapt, often more quickly than expected. More important is the potential for a new world order, which may serve as the impetus for new infrastructure investment around the globe. For corporations, this change will present both opportunities and challenges. The market should be able to resume its upward trajectory when inflationary forces diminish and when we have more clarity on the possible outcomes of these disturbing events. As for timing, it is largely up to one individual, the president of Russia. We can only hope this conflict ends soon.