The world appeared to be gradually moving into a phase of “living with Covid”, albeit with different countries moving at different paces.
Investor concerns were centered on sharply rising inflation, looming interest rate hikes and balancing this against slowing economic growth.
This has been a significant headwind for many growth-orientated stocks, and we saw the second largest spread of value outperformance versus growth spanning the past two decades.
Uncertainty has become the predominant theme of 2022 and events surrounding the Russian invasion of Ukraine have created a new source of worry for investors.
Events on the ground in Ukraine are incredibly upsetting on a humanitarian level and the evolution of the conflict is fast-changing.
We have already seen severe financial and economic sanctions including the removal of certain Russian banks from the SWIFT system and sanctions on the Central Bank of Russia – the most significant set of sanctions on a large economy in a generation.
Even under a relatively quick resolution to the conflict, the sanctions will likely remain in place for an extended period.
While the sanctions, in isolation, do not materially impact our outlook for the global economy, we remain very mindful of second derivative impacts.
Indeed, MSCI announced that it would remove Russian securities from its indices as it no longer meets its market accessibility criteria.
The situation is unpredictable, complex and geopolitical risk remains tense – its impact will be highly dependent on the extent and duration of the crisis.
While it is very difficult to see which scenario will play out, we are monitoring market implications.
Inflationary pressures are likely here to stay
Inflation has continued to surprise on the upside fueled by supply chain issues and pent-up demand, while more ‘sticky’ components such as wage growth and housing point to inflation being broader based and more persistent.
Applied history shows war is inflationary, complicating the already difficult task for central banks trying to engineer a soft landing.
So far, the clearest economic impact is via food and commodity prices. Russia is a significant exporter of commodities, accounting for 13% of global crude oil production, 17% of natural gas production as well as being a top exporter of wheat.
Higher energy prices could fuel more persistent inflation and squeeze consumer incomes.
Supply chain issues are also being exacerbated by the unfolding conflict.
Besides Russian oil and gas, in combination Russia and Ukraine are significant exporters of several minerals such as palladium, neon gas, potash, battery grade nickel, platinum, aluminum and copper.
Disrupted supply (little known companies such as Ukraine’s Cryoin play large roles in the global production of semiconductors) and the impact of sanctions on Russia is likely to add to inflationary pressures, particularly in Europe.
The interlinked nature of global supply chains means consequences could be even more far-reaching, for example Volkswagen announced halting of production at two plants due to Ukrainian parts shortage.
It’s likely inflation will peak at a higher level and later in the year than many were expecting.
Potential impacts to central bank trajectory
The playbook heading into this conflict was for most developed market central banks to begin raising rates in the near term.
Tight labour markets and inflationary pressures will likely keep central banks hawkish in the near term, however concerns about the economic consequences of the conflict in Ukraine could temper the pace of rate rises as the year progresses.
There is room for sanctions to continue to escalate, so we will see more volatility in the short term.
But, for now, growth in the US remains intact with a strong labour market and consumer.
The US Federal Reserve will likely raise rates by 25bp in March, but a more cautious tone from Fed chair Jerome Powell, suggests the odds of a 50bp rate have largely diminished.
Policymakers are facing an added challenge of interpreting supply-driven inflation, while wanting to control for any structural inflation that is building in pockets of the global economy.
The shape of the yield curve will be an important indicator to watch on whether we move from risk off to recession risk.
Eurozone headline inflation reached its highest level on record, with more than 50% driven by energy.
Given the uncertainty, it will be hard for the ECB to taper asset purchases in March, and any policy action will be data dependent.
The risk of stagflation however has increased, if growth is materially impacted amid rising energy prices.
The conflict will likely further accelerate the secular theme of sustainable investing alongside potentially increased emphasis on values-based investing.
Besides legal sanctions preventing certain investments or requiring a write-down of some assets, investors are likely to be increasingly cautious about funding any governments or corporates that could be involved in human rights issues.
We could see an expansion of conduct-based exclusion lists as investors become increasingly discerning of the social impacts of their investments.
The energy trilemma of security of supply, cost and environmental impact will likely accelerate the green energy transition in Europe towards renewables.
The debate about nuclear power’s place within the transition has also shifted (in Germany at least) with the realisation that it can provide a reliable supply while reducing dependence on oil-rich nations.
For investors, much uncertainty remains, and volatility looks set to continue.
Notwithstanding the deeply concerning humanitarian crisis, to which we hope for a near-term solution, history points to relatively short-lived market volatility around geopolitical events.
Safe-haven assets such as gold, government bonds and the US dollar act as near-term hedges.
It is important to keep a cool head, stay diversified and take a long-term perspective when price dislocations occur.
Ritu Vohora is a capital markets specialist at T. Rowe Price
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