Ukraine crisis puts pressure on energy markets. The Fed responds.

Sadly, the unfolding crisis in Ukraine continues to weigh on our hearts and it continues to inject considerable uncertainty into global financial markets. Talks at the Belarus border did not yield a de-escalation on Monday and another round of talks has been announced for today, Wednesday, March 2. Expectations are low for a breakthrough. Shelling of major city centers intensified markedly through the week.

A battery of global sanctions is likely to cripple the Russian economy, with some forecasters now estimating a 20% annualized decline in their real GDP (gross domestic product) growth for the second quarter. Amongst the sanctions, decisions to cut off most Russian banks from the global financial system and to freeze overseas assets of its central bank were particularly consequential. The Russian ruble has now lost 30% of its value against the U.S. dollar since the invasion began last week. Moscow’s equity market is closed, but trading on the iShares MSCI Russia ETF suggests a 71% decline since Feb. 16. Several large multinational corporations, including in the energy sector, have announced intentions to divest from Russia. This has many of the hallmarks of what an economist would call a sudden stop—a sharp decline in capital flows. Notorious examples of similar sudden stops include: Mexico 1994, Argentina 1995, Asia 1997, Russia 1998, Brazil 1999 and Turkey 2001.

My colleague, Andrew Pease, wrote on Monday about how we expect the global economy to be able to weather this storm, with the most notable downside risks coming from a military escalation involving NATO (North Atlantic Treaty Organization), a spike in energy prices and cyberattacks. This week we have seen further pressure on energy markets, with Brent crude oil trading 14% higher, to $115 per barrel. European economies are more vulnerable to these risks than the United States, which has built up a significant degree of energy independence over the last decade. Accordingly, European equities are underperforming this week, with the STOXX® Europe 600 Index down 2.5% and the S&P 500® Index down 1.8% as of Tuesday evening. Markets appear to be a bit calmer Wednesday morning. We will be keen to see what, if any, supply response comes out of the OPEC+ meeting today. Early indications from Saudi Arabia do not sound promising and the globally coordinated strategic petroleum reserve release from this week does not look material (yet).

Intersection of the Ukraine invasion and interest rates

Finally, I want to touch on interest rate markets. Most central bankers had adopted a more hawkish tone in recent months, as a strong global recovery and a significant inflation overshoot pulled forward the expected timing and pace of rate hikes. Regarding the war in Ukraine and how policymakers might weigh newfound economic uncertainty (dovish) against higher commodity prices and headline inflation (hawkish) is open to interpretation. The standard approach—and our read—is to conclude that higher commodity prices today do not have any predictive power about future inflation over the medium-term and central banks should therefore focus on any potential demand-side damage to the economy (dovish).

Markets seem to agree. Sovereign bond yields fell notably on Tuesday. In the United States, Fed fund futures have now totally priced out the possibility of a larger, 50-basis-point Fed rate hike in March and the market is now only expecting five total rate hikes for this year (down from seven hikes just a few weeks ago). Chair Powell's semiannual monetary policy report to Congress this morning still guided toward a rate hike in March, but he also flagged highly uncertain effects of the invasion of Ukraine onto the U.S. economy and the need to be nimble in responding to an evolving outlook. Similar dovish repricings were observed across Europe and in Canada as well. Our central bank forecasts have generally been less aggressive than the market and so this directionally reflects a convergence toward our view.

The bottom line

We believe that parking our emotions and staying invested through geopolitical scares is best practice. We will continue to lean on the discipline of our cycle, valuation and sentiment (CVS) decision-making process throughout this volatility. Market psychology is pessimistic, but it has not yet reached an unsustainable extreme of panic similar to what we saw back in March 2020 when we were adding to risk across our portfolio strategies. As always, we are committed to dynamically managing both risks and opportunities on behalf of our clients. And to keeping you informed as well.