Putting the Russian Invasion of Ukraine into Perspective

February 25, 2022

Russia’s invasion of Ukraine this week captured the world’s attention and roiled financial markets.  It is important to remember, however, that the initial sentiment and market uncertainty can sometimes seem more concerning than the actual long-term effects of the event itself.  In that vein, we would like to take a moment to break down some of the factors involved as the markets digest this particular crisis.

Yes, Russia’s full-scale invasion of Ukraine this week has significantly increased major uncertainty in global markets. While predicting geopolitics is nearly impossible, we hope this note gives some reassurance while articulating our view on the potential impact of the crisis. Know that your Commerce Trust Portfolio Manager welcomes your questions and phone calls at any time.

In general, our focus remains primarily on the impact to financial markets as global Central Banks, especially our Federal Reserve, begin to raise interest rates to control surging inflation while dampening economic growth. While this crisis reinforces our existing concerns, it likely puts even more pressure on near-term inflation making it even tougher to “soft land” the world’s economy, unfortunately complicating what was a rather straightforward cyclical recovery marked by episodic Covid interruption.

From a global standpoint, the Russian-Ukraine crisis primarily impacts the energy markets acting as one more large “supply-side” shock. The biggest impact will be on energy prices due to Europe’s heavy dependence on Russian oil and natural gas.  Worldwide, aggregate commodity price indexes were already at their highest levels ever and will remain elevated given Russia’s share of global supply, especially since additional sanctions were just levied. Russia is also a key supplier of specific niche metals. To the extent those exports are also impacted, we might expect new supply chain bottlenecks to develop with negative repercussions, providing even more inflationary pressure while hurting economic momentum.
From a monetary policy perspective, this crisis will likely slow Federal Reserve and European “hawkishness.” Central Banks may become wary of the growth implications of additional policy moves beyond those that have already been signaled.  It likely takes away any chance of an initial 50-basis point hike (one-half percent) at the forthcoming Federal Open Market Committee meeting on March 16 and pushes our normalization of European cash rates.  The U.S. market had been discounting as many as seven rate hikes this year, but may now be overestimating Central Bank hawkishness as they will need to consider the additional uncertainty and tightening of financial market conditions occurring from this Russian conflict. 

From an equity market perspective, we expect value stocks to outperform growth and international markets to hold up a bit better against a rising U.S. interest rate backdrop. Given the potential ripple effects of the invasion on growth in general, it is likely that earnings expectations will be revised downward a bit. Historically, value stocks have tended to outperform growth stocks in an inflationary and/or rising rate environment.  While we have been “underweight” international stocks in general, their valuations are much lower than domestic stocks and this conflict has only further discounted them, especially the emerging markets. Investors should consider taking advantage of this by adding back to their international positions.  Furthermore, in general, global stock markets are typically higher one year after a major geo-political shock. 

For fixed income markets, a rush to safety will eventually fall prey to a rising interest rate environment.  The initial “flight to quality” and rally in U.S. rates is likely to give way ultimately to the current inflationary backdrop, pushing rates up along the curve as we work (slowly) through the crisis.  As such, we remain shorter than bond market benchmark maturities; the Central Bank will still be raising rates, just not perhaps as fast as the market thought last week. This crisis also will likely result in some spread-widening, particularly in Emerging Markets (EM).  As such we may consider virtually no exposure to EM debt and consider domestic high yield and floating rate bonds as a substitute.

What to watch for during these turbulent times. We will pay particular attention to several key variables as the crisis plays out, starting with the price of oil.  The shape of the U.S. Treasury curve will also help inform investor views on growth expectations. We are particularly keen to monitor Central Bank communications, particularly looking for any signal that the Federal Reserve will tone down their more recent hawkish bias. We also expect sanctions to be expanded and we will be following their potential impacts.  

Overall, we are still not tremendously concerned about recession risks, given the impressive strength and momentum of the U.S. economy recovery driven by job growth, increased wages, pent-up demand, and inventories that need to be replenished.  But with any international military conflict, uncertainty has risen and with that a wider range of potential outcomes. 

Finally, we provide a few final thoughts.

Due to its fall in economic stature from the Cold War days, Russia is much smaller.  Its GDP is about 8% the size of either the United States or the combined European Union/British economy.
The Russian ruble has hit its lowest level ever versus foreign currencies and its stock market had its biggest collapse, down 33%, since their debt default back in 1998, while the S&P 500, Dow and Nasdaq posted late gains.   

The greatest direct impact will likely be felt in the energy and raw material markets, especially in Europe where Russia supplies 30% of their total energy needs and about 40% of their natural gas.  Rising energy prices and an upward push on commodity prices in general will hurt consumers in Europe, but also around the world.  In addition, Russia also has large international leverage with some important raw materials – including aluminum, titanium and uranium.

Finally, looking at past geopolitical events generally indicates that much of the stock market downside is captured leading into the event and the day of the event.  As we said, equity markets historically rally in the months following most of these crises. As always, if you have questions, please contact your portfolio manager. 

Past performance is no guarantee of future results, and diversification does not guarantee a profit or protect against all risk.

This summary is intended to provide general information only and is reflective of the opinions of Commerce Trust.  This material is not a recommendation of any particular security, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional.  Commerce does not provide tax advice or legal advice to customers.  Consult a tax specialist regarding tax implications related to any product and specific financial situation.

The opinions and other information in this commentary are as of 02/25/2022.

Commerce Trust is a division of Commerce Bank.

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