The outbreak of war between Russia and Ukraine shocked the world, and our hearts and thoughts go out to the millions of people suffering from the horrendous humanitarian tragedy on the ground. The geopolitical tension is also adding new challenges and uncertainties to a world that is already walking a fine line between growth and inflation. In the near term, a recession seems likely in Europe and potentially even in the US, depending on the eventual path of monetary policy tightening. The margin for error is thin, and a policy-induced hard-landing may pose a considerable threat to risk assets.
The second-order effects from the geopolitical fallout are also likely to linger for a while. Depending on their reliance and proximity to Russian commodity supplies, new winners and losers are expected to emerge at the country, sector and industry levels. For investors, the increased dispersion and new economic and political alignments present opportunities for active management across country, security and sector selection and away from passive beta exposures. Any near-term setbacks in de-carbonization are likely to be made up over time through an expedited path to green energy which is hoped to wean countries from dependencies on fossil fuel producers in the medium to long term.
Where We Are Now
Shortly after Russia’s invasion began on Feb. 24, the S&P 500 slipped into its first correction in nearly two years, while European stocks are now trading in bear market territory. Yields declined sharply before rebounding, curves flattened, and interest rate volatility, as measured by the MOVE index, spiked to elevated levels seen at the start of the Covid-19 pandemic.
What’s more, hopes of a quick and orderly resolution to the fighting in Ukraine are fading. Sanctions on Russia and new supply chain bottlenecks have contributed to a spike in prices for oil and other energy sources, metals and agricultural commodities. The US 10-year break-even rate, which measure the difference between the nominal yield on the 10-year US Treasury note and the real yield on 10-year Treasury Inflation Protected Security, is approaching 3% and 5y5y inflation swap rates have surged to their highest level in more than five years. The takeaway for investors: inflation appears likely to stay elevated for longer than market participants had thought just months ago.
All of this has put pressure on equity multiples, especially for growth companies. On the contrary, the rally in energy and energy equities have boosted the relative performance of value stocks. As of March 11, MSCI World Value has outperformed Growth by about 4% since the Russia-Ukraine fallout.
Central Bankers’ Dilemma
Higher commodity prices will complicate the Federal Reserve’s goal of dragging inflation back down to its 2% target over the next 12 to 18 months. If prices remain higher for longer, Fed policy makers can be more inclined to hike rates rapidly and substantially to keep inflation expectations in check. But if they raise rates by too much, they risk starting a recession. On the other hand, looser monetary policy in the face of today’s inflationary challenges could lead to stagflation. Hitting that 2% target while also maintaining positive, at-trend growth, will be difficult. The room for unintended consequences and a potential policy error have increased substantially since the Ukraine invasion.
Even before the war began, increased demand and limited supply had energy prices in a bull-cycle. Supply shortfalls in Russia, a major global energy producer, are unlikely to be replaced by other producers without triggering additional price increases. Also, governments have been reining in fossil fuel consumption to meet de-carbonization goals. Calls to boost supply represent a U-turn for the oil sector, and it may take significant policy changes to incentivize energy firms to invest in increased oil and gas production. As a result, commodity spot and futures curves are already pricing in near-term supply disruptions. The longer the fighting in Ukraine goes on, the higher prices are likely to go—at least until demand weakens enough to balance the supply restrictions.
Economic Growth and Investment Strategy
In light of these challenges, we have downgraded our outlook for growth in 2022 and 2023, particularly in Europe. New sanctions-induced supply chain disruptions and spikes in commodity prices are likely to create major regional and country-specific economic disparities that lead to differences in the rates of growth and inflation. At the top of the list is Europe, considering its reliance on Russia for energy and other commodities.
We expect that high energy bills—which may remain high even when the fighting stops—will reduce household purchasing power and suppress discretionary consumption. Consumers may also choose to reduce energy consumption in favor of other goods and services. This may discourage capital expenditure at traditional fossil fuel energy firms, and lower capital expenditures on downstream corporations and end-consumer spending may dampen growth for prolonged periods of time.
More broadly, we expect the war, combined with the ongoing effects of the pandemic, to add increased uncertainty to the investment landscape and complexity to global trade and geopolitical dynamics. That will have implications for investment strategies and portfolio management. We expect that success going forward will mean less reliance on passive beta exposures and more on active management.
We believe this year’s public equity selloff is likely to spread to private equity valuations, which are likely to be marked down after the first quarter ends, especially in the growth portfolios. A material selloff of risky assets, followed by a geopolitical stabilization, may present a buying opportunity, especially in emerging market equities whose valuations were already attractive before the Russia-Ukraine crisis. These assets may also benefit from the re-distribution of index weights tied to Russia’s removal from the MSCI Emerging Market Index. Countries that may stand to gain include Thailand, Malaysia, South Africa, and Mexico.
We also think the interplay between green energy and fossil fuels will be influenced by economic security considerations in the short-term and energy independence in the medium- to long-term. Following the Russia sanctions, traditional energy sources (for example, coal) had to be turned back on in order to make up for the supply shortfall, especially in Europe. These short-term setbacks for de-carbonization are unavoidable, as economic security and survival take precedence during war. Note that Europe’s reliance on Russian energy imports has been built up over decades, and bringing new plants and supplies online will also be a time-consuming process. In these circumstances, the inflation implications from energy may linger for longer, and clean energy may take longer to be economically attractive. However, the situation also underlines that the transition to clean and independent energy sources must take place faster than previously planned. Despite any temporary reversals, we think current events will eventually serve as a catalyst to accelerate the green transition.