As we close day 12 of the Russia-Ukraine conflict, we are unfortunately reminded about the human cost of war. There have now been two formal attempts by Russian and Ukrainian leaders to end the conflict, but no armistice has been reached yet. We join the chorus in hopes of a rapid and peaceful resolution.
The still fluid and fast-moving situation is clearly impacting financial markets, which were already off to a volatile start in 2022. Geopolitical risk is always present but not always visible and is now being “priced in” by market participants. Government sanctions, corporate self-sanctions and investor divestment and exclusion aimed at Russia have been implemented in an unprecedented and sweeping attempt to end the war.
Since February 22nd, two days before Russia formally invaded Ukraine, the S&P 500 Index is down 2.4% as investors grapple with the potential economic fallout from the conflict. International equities have struggled even more with developed international equities down 7.3% (as represented by the MSCI EAFE Index) and emerging international equities (MSCI Emerging Markets Index) down approximately 10% over the same time fame. Commodity prices have surged in the wake of Russian sanctions and supply disruptions in Russia and Ukraine, both significant players in global agriculture and energy.
Bond yields have declined as investors flock to safety and as economic growth expectations moderate. The benchmark 10-year Treasury yield has compressed from 1.95% on February 22nd to 1.75% today. Moreover, the yield curve (yields of U.S. Treasury bonds across the maturity spectrum) has flattened over that time frame, indicating increased concern about the economy by market participants.
What does this all mean to our views and expectations? As regular readers are familiar, we use a “3 E’s” framework when assessing our views on the financial markets. The first two E’s, Economy and Earnings (or corporate profits) are consistent members of the framework since they both are important fundamental drivers of asset values. We rotate the third E each year as we try to anticipate what external factor will have the most significant impact on markets and asset prices. In 2022, our third E is “Easy Money”, or the removal of emergency accommodation by both the Federal Reserve and the U.S. government as we continue to transition to the mid-cycle of the COVID-19 recovery, and with inflation running too hot for comfort.
Economy
Entering 2022, we expected the economic recovery from COVID to continue, albeit at a more normal pace. With consumers in good financial condition and ready to spend, and businesses in a similarly strong position, the key drivers behind global GDP continue to support more recovery. Employment trends, which had lagged other metrics in 2021, were also positioned to improve. Primary risks were inflation, new COVID variants and any slowdown on the employment front.
While we remain optimistic that underlying economic strength can withstand the Russia-Ukraine conflict, risks to our outlook have clearly increased. Inflationary pressures are likely to rise given the recent escalation in oil and grain prices which could force the Fed to act faster and more aggressively than before. Outside the U.S., the conflict increases the economic risk for European and Asian economies more significantly than in the U.S. given a higher dependence on Russian energy and other input commodities.
Corporate Earnings
Similar to the economy, we came into 2022 expecting another year of solid but more historically normal levels of corporate profit growth. Inflation and supply chain pressures have been navigated well by management teams and we believe the economic tailwinds can propel profits higher. The Russia-Ukraine conflict is exacerbating the inflationary and supply chain pressures on profit and loss statements and could begin to impact demand if requisite price increases outpace demand elasticity. Currently, our base case calls for earnings growth consistent with long-term historical averages (or about 8%-10% year-over-year) but given the current geopolitical backdrop, more tangible downside risks to our expectations are surfacing
Easy Money
The Fed entered 2022 indicating that it would be on the path of monetary tightening during the year. The central bank’s dual mandate (price stability and full employment) required it as inflation had risen above the 5% level throughout the second half of 2021 and economic progress no longer required the emergency accommodation that has been in place since the COVID downturn. We expected and continue to expect the removal of emergency accommodation and support to cause higher levels of market volatility this year, especially relative to the subdued levels experienced in 2021.
The Russia-Ukraine conflict will likely squeeze both sides of the Fed’s dual mandate. On price stability, the added inflationary pressure from higher oil and other commodities, and supply chain disruptions as a result, have the potential to push the Fed to act faster and more aggressively than previously planned. On the full employment front, any impacts to demand caused by higher inflation or global economic slowdown could lead to less progress on the jobs front here in the U.S. Ultimately, the conflict makes the needle the Fed is attempting to thread even smaller.
Conclusions
We recognize that periods of elevated market volatility are stressful for all participants. The Russia-Ukraine conflict has accentuated several risks to the economy and other market drivers we’ve laid out herein. It has also caused markets to incorporate more uncertainty in valuations. Accordingly, we continue to emphasize getting the asset allocation decision right at the beginning of the investment process and utilizing periods of volatility as opportunities to take advantage of dislocations that occur. We also remain focused on knowing what assets we own, the role each plays in an overall portfolio and the durability of each asset during periods of stress.
In recent history, markets have demonstrated relatively short attention spans regarding geopolitics, though the combination of circumstances currently is amplifying the impact of Russia and Ukraine. Clearly, the fact that nuclear powers are involved also increases the level of unease. Ultimately, we will remain focused on the evolving impacts of the Russia-Ukraine conflict while not becoming distracted away from the other important factors we believe will affect markets.