Russia invaded Ukraine on February 24th to prevent it from becoming a defense partner of the US and its allies (NATO). This put to rest speculation that President Putin's aims might be more limited, such as seizing areas near the border controlled by Russian-backed separatists or a larger area of land along Ukraine's southeast coast to "build a land bridge to Crimea."
Putin's goal now appears to be regime change, toppling the current government and replacing it with a pro-Russia regime that will be subordinate to Moscow. Russia is unlikely to withdraw troops until the government in Kyiv has changed hands and, as no wars are bloodless, there will be a steep human cost to this tragedy. Families will be separated and lives will be lost. The war also raises the prospect of a humanitarian and refugee crisis for Europe.
As the full-scale invasion surprised investors, the initial market response was predictably risk off with stock markets around the world plunging and safe havens, such as gold, treasury bonds, and the US dollar, surging. However, this reaction was short lived as risk assets recovered later in the day and safe havens pulled back. This was followed by a strong rebound in global stocks market on Friday. So, what explains the dramatic turnaround?
"Buy to the sound of cannons and sell to the sound of trumpets." Nathan Rothschild is said to have uttered these words during the Napoleonic Wars. Historically, geopolitical events have not caused sustained equity bear markets. While they have caused significant draw downs in equity markets, these have typically been temporary declines that investors benefitted from buying. My colleague, Ed Keon, chief investment strategist for the Global Multi-Asset Solutions group at PGIM Quantitative Solutions, chronicled these trends in a research piece written 20 years ago.¹ As noted in the piece, fear of conflict tends be bad for equity markets with the strife leading up to conflicts resulting in steady drops in equity prices. However, "markets have tended to bottom at moments of maximum peril or at the start of actual fighting." So perhaps investors were breaking out the old playbook and buying to the sound of cannons.
However, as also noted in the aforementioned piece "economic conditions have sometimes trumped conflicts as the key driver of equity prices." Geopolitical tensions that caused energy shocks, for example, have coincided with recessions and equity bear markets in the past. This appears to be the key economic and market risk related to the current conflict as the European economy is heavily dependent on Russian energy. Any cessation of Russian energy exports to Europe, whether by European boycott or Russian embargo, would cause an energy crisis for Europe and certain recession.
Equity markets were likely also heartened by President Biden's speech on February 24th. While he announced sweeping economic sanctions against Russia (and more were added over the weekend) none was designed to halt the flow of Russian energy exports. Putin seems unlikely to withhold Russian energy as it would remain a lifeline to the Russian regime that will otherwise be hobbled by economic sanctions.
Investors also appear to be assuming that the crisis will be limited to Ukraine and that Russia will not attack a NATO country. We can also take some comfort in the fact that the US and Russia have 73 years of success in avoiding direct war with one another.
Headwinds for Global Growth and Increased Inflation Risks
The global economy had significant momentum recovering from the COVID-induced recession when the conflict struck. Increased uncertainty for consumers and businesses and the negative impact on global supply chains mean global growth forecasts should see downward revisions from here. While we do not think this will derail above-trend growth in 2022, risks are clearly to the downside. Those economies closest to the epicenter of the crisis, i.e., the Eurozone, are most at risk. In contrast, the United States should be relatively more insulated.
A rising geopolitical-risk premium is likely to support continued strength in commodity markets at a time when inventories and spare capacity are already low. This should keep upward pressure on inflation and inflation expectations. This combination of lower growth and higher inflation is clearly not a positive for equity markets, but US and global stocks have already experienced 10% corrections and the NASDAQ composite has seen nearly a 20% decline. If the military conflict is short and energy supplies are not interrupted, the historic playbook of "buy the geopolitical dip" could be the right one.
That said, there is the potential for much more to go wrong, so significant downside could still lie ahead. This shock is coming at a particularly difficult time for global policymakers. With fiscal authorities already having gone big on deficit spending to offset the economic shock from COVID back in 2020 and early 2021, the positive impulse from fiscal policy has now past and is turning negative. Further, with inflation already running at a multi-decade high, some major central banks have fallen behind the curve and need to play catch up with hiking rates. The threat of increased pressure on already elevated inflation could cause some central banks to tighten policy more than previously anticipated. On the flip side, the risk of a growth shock could prompt some central banks to exhibit more caution and ease the pace of expected rate hikes. Either way this uncertainty increases the possibility of a policy mistake and potential recession in 2023.
So far, we have avoided making major moves in our multi-asset portfolios as we continue to assess both market dynamics and the path of the military conflict. We would be inclined to reduce exposure to global stocks should the relief rally continue without a resolution of the conflict. Overweight positions in energy/commodity-related assets are a good hedge against a worse-than-expected outcome. Investors should prepare for significant volatility in risk assets in the weeks ahead. We are likely not out of the woods just yet.
¹The Winds of War, A Compilation, Prudential Financial Research, Quantitative Strategy, Edward Keon, September 13, 2002