Globally, stocks sold-off as the tensions between Russia and Ukraine escalated. Emerging markets suffered the most with a 4.8% drop as Russian stocks dragged the index lower. European and Japanese stocks also fell with the indices down 2.3% and 2.9%, respectively. U.S. stocks held up better with the S&P 500 gaining 0.8% and the NASDAQ rising by 1.1% as interest rate pressures eased. The 10-year U.S. Treasury yield was little changed at 1.96%.
The ongoing conflict between Russia and Ukraine has led to a swift response from NATO allies with the severity of sanctions increasing and the pressure on the Russian economy rising. In response, Russia’s central bank has also taken dramatic actions by raising the country’s policy rate from 9.5% to 20% and shutting down the country’s stock and derivatives exchanges. Thus far, sanctions on the country’s energy sector have largely been avoided to limit the collateral damage from surging energy costs.
On Wednesday, Fed Chair Powell will speak to the House Financial Services Committee. Investors will be watching for any clues as to how the conflict may impact monetary policy. In response to the conflict, markets are now pricing in just a 9% chance of a 50-basis point rate hike in March and a 40% chance of six rate hikes by year-end.
A Swift Response to Russia
There is always a human cost to war, and our thoughts are with all of those who may be caught up in this conflict. The human impact is always, always more important than the financial impact and we acknowledge that clearly. However, the recent conflict between Russia and Ukraine also has financial implications with investors finding themselves on a bumpy, uncomfortable rollercoaster ride throughout the first two months of 2022. First it was the hawkish pivot from the Federal Reserve that rattled markets and now it is the military conflict between Russia and Ukraine. These events have two things in common: 1) both events are causing a great deal of market uncertainty and 2) both are likely to have some impact on inflation.
Let’s start with the recent conflict in Ukraine. Russia’s invasion of Ukraine was well telegraphed with U.S. intelligence saying that an attack was imminent for some time, but markets were caught off guard as the invasion moved beyond Russian troops in the Donbas region to a potential regime change. The initial response in Russia’s stock market was deep and indiscriminate with the MSCI Russia index plunging 38% on the day of the invasion. The following day, Russia’s stock market surged 26.5%, but looks to experience significant losses once again when the country’s exchanges reopen (both stock and derivatives exchanges in Russia were closed in response to the ongoing turmoil). The S&P 500, on the other hand, has risen 3.7% since February 23rd as investors have moved into technology stocks as interest rate pressures have eased some, clean energy stocks on a reduced desire for fossil fuel dependence, and aerospace and defense stocks on expectations for higher defense spending in the future (Germany has stated that it will boost its defense spending from 1.4% of nominal gross domestic product to 2.0%, see figure 1).
Market volatility seems likely to remain elevated over the near-term with the situation remaining very fluid. This past weekend serves as an example of how fast-moving developments have been with several Russian banks being banned from the Society for Worldwide Interbank Financial Telecommunications (SWIFT) system, which is a network that is used by banks to send an average of 42 million messages a day about the transfers of money and other financial transactions. Though it should be noted that SWIFT can still be used for energy payments and that Russia does have its own messaging system called SPFS that was launched in 2014 in response to previous threats to cut the country off SWIFT. The SPFS system allows Russian banks to message within Russia, but with higher transaction costs. We suspect that energy payments were not targeted because NATO allies want to limit the impact of soaring energy costs on their own domestic economies. However, this could change if Russia decides to “share the pain” and limit energy exports to Europe in retribution.
Other moves over the weekend included banning Russia’s central bank from buying foreign currency, banning U.S. companies from doing business with Russia’s central bank, and banning Russian aircraft from using European Union airspace (Russia has banned EU and UK aircraft from Russian airspace as well). These actions are designed to limit the Russian central bank’s ability to use a vast bulk of its foreign reserves to support its currency (though it should be noted that there are some reserves that can still be sold like gold). In response to these actions, Russia’s central bank hiked interest rates from 9.5% to 20% (see figure 2), the stock market and derivatives markets were closed, $9 billion of reserves were released, and foreigners were banned from selling securities.
Combined, these sanctions have been both swift and severe. However, these sanctions have been designed to avoid collateral economic damage that could occur with sanctions that target Russia’s energy complex. As an example, when Iran was kicked off of SWIFT in 2012, the country lost half of its oil export revenues and 30% of its foreign trade. With oil and natural gas production accounting for about 40% of Russia’s total revenues, this would likely have a significant impact on the Russian economy. While those actions have not yet been taken, investors can’t rule them out with Canada recently deciding to curb its imports of Russian oil.
What happens in the commodity complex may be the most important question for financial markets and the global economy. If commodity prices spike and remain elevated, it will serve as an additional tax on consumers and crowd out spending on other stuff. One estimate we have seen is that $125 per barrel crude oil over the next two quarters would shave off ½ a percentage point from global GDP. The global economy should be able to absorb this with geopolitical events rarely serving as turning points for the global economy (please see our CIO Strategy Bulletin | Ukraine for additional insights), but inflation levels are already elevated in many countries and several central banks are on the verge of tightening monetary policy. This clouds the inflation outlook even further (see figure 3).
How Will This Impact the Federal Reserve?
Fed speakers have yet to materially change their stance, but European Central Bank (ECB) council members have stated that the ECB may put even greater emphasis on flexibility as it exits stimulus measures and moves towards raising rates. Investors may hear something similar from Fed Chair Powell who will be speaking to the House Financial Services Committee on Wednesday, March 2nd. Thus far, markets have started to price in reduced odds of a 50-basis point rate hike at the March 16th Federal Open Market Committee (FOMC) meeting, but it hasn’t been completely taken off the table (see figures 4 and 5).
With the odds of a 50-basis point rate hike in March falling to just under 10% and the number of rate hikes expected by the end of December 2022 now falling to five rate hikes from six rate hikes, U.S. markets have held up well with technology stocks rallying 4.7% since February 23rd. This somewhat mirrors past geopolitical events with the impact often not long-lasting. As figure 6 shows, the S&P 500 typically experiences about a 5% total drawdown but recovers after about a month. It seems too early to say with confidence that market volatility will subside soon, but some clarity on the path of monetary policy would likely help investors to clear at least one major hurdle. Over the long-term, U.S. equities having proven time and time again that each crises can eventually be overcome (see figure 7).
S&P 500 Returns
Number of Days
U.S. Pulls Out of Afghanistan
Saudi Aramco Drone Strike
North Korea Missile Crisis
Bombing of Syria
Boston Marathon Bombing
London Subway Bombing
U.S. Terrorist Attacks
Iraq's Invasion of Kuwait
Cuban Missile Crisis
North Korea Invasion Of South Korea
Pearl Harbor Attack
average percent change for S&P 500 from hike to high across all given records in this table is 21.4
average percent change for number of months from hike to high across all given records in this table is 51.4
Average Excluding Pearl Harbor:
median percent change for S&P 500 from hike to high across all given records in this table is 12.7
median percent change for number of months from hike to high across all given records in this table is 33.1
|Index||Weekly Chg change in percent||YTDyear to date change in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||3.3 bps||45.1 bps||44 bps||1.96%|
|Index||Weekly Chg change in percent||YTD year to date in percent||12 Months12 month change||Div. Yield division yield in percent|
The Week Ahead
|3/1||10:00||Construction Spending MoM||JanJanuary||0.1%||0.2%|
|3/1||10:00||ISM Prices Paid||FebFebruary||77.5||76.1|
|3/1||10:00||Wards Total Vehicla Sales||FebFebruary||14.45m||15.04m|
|3/2||8:15||ADP Employment Change||FebFebruary||375k||-301k|
|3/3||10:00||ISM Services Index||FebFebruary||61.1||59.9|
|3/4||8:30||Change in Nonfarm Payrolls||FebFebruary||405k||467k|