Paul O’Connor, Head of the UK-based Multi-Asset Team, addresses the initial market response to events unfolding in Eastern Europe.
- From what we saw in the early hours of European trading yesterday (24 February), investors’ initial response to news of Russian action was to de-risk, as visibility faded on the global economic and geopolitical outlook.
- But the mood transition was remarkable. By the time the US trading session got underway, investor psychology had shifted towards a search for market mis-pricings, from the initial wave of panic selling.
- If the military conflict remains localised, global economic spillovers are likely to be dominated by the scale and the duration of the commodities’ price surge, and also reinforced by any adverse impacts on business and consumer confidence.
We approach this situation with humility as we have no clear precedent for the sort of attempted regime change that now appears to be underway in Ukraine. We are witnessing momentous events unfolding in Europe and are mindful of potentially destabilising political consequences beyond Ukraine.
The Russian invasion raises questions about the integrity of the whole post-war global diplomatic security architecture. Relations between Russia and the West will never be the same again. Spillovers could plausibly extend to the Baltic states, the Balkans and even Asia. Furthermore, the way the West responds to Russia’s action might well influence how China evaluates its stance on Taiwan.
A changing mood from investors
For now, investors are focusing on evaluating the probable dimensions of the unfolding conflict. We expect markets to differentiate between action that leads to rapid regime change in Ukraine and one that involves a prolonged military conflict. Price action as the day (24 February) progressed suggested that investors were taking inspiration from the historical playbook, which suggests that big geopolitical shocks to financial markets, including localised wars, are usually good buying opportunities.
From what we saw in the early hours of European trading yesterday, investors’ initial response was to de-risk, as visibility faded on the global economic and geopolitical outlook. That sparked a reflex, broad-based selling across risk assets, carnage in Russian markets, a big squeeze in commodities and a predictable rotation into safe havens, such as gold.
The mood transition in financial markets yesterday was remarkable. By the time the US trading session got underway, investor psychology had shifted towards a search for market mis-pricings, from the initial wave of panic selling. There may be plenty more work to do here, as the second-round effects of the events in Ukraine are evaluated. The big issues to consider, in our view, will be the financial consequences of sanctions, the economic impact of the commodities squeeze and the potential response of major central banks.
The challenges ahead
If the military conflict remains localised, global economic spillovers are likely to be dominated by the scale and duration of the commodities’ price surge and reinforced by any adverse impacts on business and consumer confidence. Clearly, as things stand, both effects seem to be sizeably bigger in continental Europe than elsewhere. In our view, a prolonged commodity squeeze could plausibly knock a sizeable chunk off eurozone growth, but the impact on the US and other economies would probably be much smaller.
The impact of surging commodity prices on inflation complicates an already difficult task facing central banks. While the current market uncertainty seems to extinguish some of the more hawkish scenarios for the US Federal Reserve (Fed) – such as a 50-basis points rate hike in March – we may not see much impact on US interest rates beyond that. The conflict is unlikely to have significant influence on the Fed decision-making process at this point, in our view, unless it alters expectations about the outlook for US labour market dynamics.
It also presents real challenges for the European Central Bank (ECB). The first-round effect is the upward pressure on inflation, which has already reached a 30-year high in Europe.1 Despite this, there are few signs of overheating in the eurozone economy. Domestic demand is subdued, wage pressures are not as strong as in the UK, and in the US, most inflationary pressures are being imported. With economic confidence now at risk, the ECB is more likely to regard the commodity shock as a headwind to consumers’ real incomes than a source of sustained inflationary pressures. It is our view that the conflict probably puts a lid on eurozone interest rates, turning attention to the challenge the ECB will face to try to get interest rates significantly above zero.
Implications for investors
In Europe, we expect the unfolding events may cast a shadow for many months to come, so we could see more challenging conditions for eurozone stocks compared to the UK and emerging markets. European credit looks appealing as investor outflows lift bond yields and spreads. We see little risk of sustained upside to short-end rate expectations in Europe but expect growth to be resilient enough to keep recession probabilities low. Elsewhere, the subsequent market moves following conflict escalation may offer opportunities to ‘buy the dip’ in US growth stocks, as seen in the markets on 24 February.2
1Source: Bloomberg, Euro Area harmonised index of consumer prices, 31 January 2022
2Source: The Wall Street Journal, Growth Stocks Surge as Investors Back Away from Value Shares, 24 February 2022
Buy the dip: purchasing an asset after it has dropped in price on the belief that the new lower price represents a bargain or short-term decline, and that the asset, with time, is likely to bounce back and increase in value.
Growth stocks: investors expect earnings for growth stocks to grow at an above-average rate compared to the rest of the market, and with this, their share prices.
Hawkish: hawkish monetary policy or monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy, typically by raising interest rates and reducing the supply of money.
Spread/credit spread: the difference in the yield of a corporate bond over that of an equivalent government bond.
Yield: the level of income on a security, typically expressed as a percentage rate. For a bond, this is calculated as the coupon payment divided by the current bond price.