“There are decades when nothing happens; and there are weeks when decades happen” – Vladimir Llyich Lenin.
Almost a century after the above words were declared, global developments during the last few weeks suggest that they still ring true. Hopes of a truce between Ukraine and Russia seem low as the war continues. The details that have emerged from the negotiations suggest that no real progress has been made. Nevertheless, the short-term impact of war on the North American and European equity markets has been completely reversed. As of April 1st, 2022, the S&P 500 Index is up by ~+7.7%, the S&P TSX Index is up by ~+6.2%, and the STOXX Europe 600 index is up by ~+1.6% since the start of the Russian invasion of Ukraine in February.
The story is different for the first quarter of 2022 where except for the Canadian Index (S&P TSX), which was up by ~+3.8%, the US and European indices (S&P 500 Index and STOXX Europe 600 Index) are down by -5.9% and -4.60%, respectively. The price action indicates the narratives of inflation and the start of an interest rate hike cycle by the central banks that have been more relevant to the financial markets.
The short-term impact of war might be limited, however, the trends that have been set in motion are sure to dictate the trajectory of financial markets in the years to come. For instance – it is certain that Europe will have to invest substantially to reduce/eliminate its dependency on Russian energy imports. While Europe is likely to embrace sustainable forms of energy, fossil fuels will also play an important role as Europe will need readily available sources to achieve their energy needs. This implies an increase in capital expenditures and a higher inflation rate related to higher energy costs. The Western countries will also need to increase their capital expenditure on military equipment and preparedness.
Ukraine and Russia together account for ~25% of the world’s wheat production. Wheat prices have risen since the start of the war as supplies have been disrupted. Russia is a large exporter of fertilizers. If the World decides to force sanctions or seek to sever ties with Russia, this could mean more food inflation. Since all this is coming to pass at a time when inflation is already running hot and supply chains are still fractured by the pandemic, Central Banks looking to tighten monetary policies to tame inflation have a challenging task ahead.
In March, the Bank of Canada and the US Federal reserve started the interest rate hike cycle by increasing the policy rates by 25 basis points. With inflation in Canada at 5.7% and in the US at 7.9%, market participants are now expecting the Central Banks to accelerate the pace of rate hikes with another 6 to 8 increases of 25 basis points each over the remainder of the year. The challenge for Central Banks is to determine the neutral policy rate, i.e., the rate at which interest rates are not too low to further add inflationary pressures and not too high to curb economic growth. The price action in bond markets suggests bond markets are expecting a policy error that could lead to an economic recession. As of April 1st, the most-watched section of the US yield curve (2-year-10-year) has inverted, i.e., the yield on a 2-year treasury is higher than the yield on a 10-year treasury. While the usefulness of an inverted yield curve in predicting a recession is often debated due to potential false positives, historically, an inversion of a yield curve has often preceded an economic recession by ~18-24 months (see chart).
Chart 1. US Yield Curve 2Y-10Y spread and US Recession
On the other hand, despite some jitters, equity markets have remained overall relatively resilient. Given that equity markets typically peak 3 to 6 months before the actual recession hits, and corporate earnings expectations have yet to show any sign of weakness, we think it is too early to look negatively at equities. Nevertheless, as a hedge against the rising interest rate environment and the increasing uncertainty, we think it is prudent to increase allocation to the low assets in a portfolio. The fixed income asset class could stage a rally in the near term after producing a year-to-date decline of approximately 6% to 7%, however, high inflation and rising interest rates indicate that the outlook remains challenging. Looking ahead, we think that increasing exposure to select pockets of markets with a skew towards high quality, low valuation, and low duration assets is the best way forward.