Treading Carefully

The human impact of war is always, always more important than the financial impact and our thoughts are with those who are caught up in this conflict, including Citi’s employees in Ukraine. If we had to sum up recent market action, it would be that investors are treading carefully as the list of potential headwinds grows. Thus far, U.S. equities have held up well with the S&P 500 essentially flat since the February 24th Russian invasion of Ukraine (this compares to a 16.2% drop in the MSCI Europe USD index and a 52% plunge in the MSCI Russia Index year-to-date). The primary question facing investors is whether the conflict will lead to a lasting impact on commodity prices and a new global supply shock that drags down global economic growth.  

We believe there are three factors that investors need to consider: 1) how much do commodity prices rise (oil, natural gas, wheat, etc.) and will it be sustained, 2) how much will inflation be impacted, and 3) how patient will the Federal Reserve be? Commodity markets have been extremely volatile as a result of the conflict with price spikes occurring in numerous commodities ranging from natural gas to wheat. However, none are more visible than the global oil market with Brent crude oil prices briefly rising well above $130 per barrel before falling back to $120 per barrel after German chancellor Scholz pushed back against a ban on “essential” Russian energy imports (see figure 1). Natural gas prices are also up materially.

This graph shows the Intra-day ICE Brent Crude Oil Futures

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An interesting aspect of the recent spike is that Western nations have not targeted the Russian energy sector and yet prices are still spiking in anticipation of a removal of Russian energy supplies from the global market as private refiners look to source oil elsewhere. Essentially, corporate interest and reputational risk are having an impact despite the current lack of targeted sanctions. It has been estimated that about 4.3 million barrels per day of Russian oil may have been sidelined due to this.

With OPEC+, which includes Russia, signaling that it does not intend to raise output in response to the conflict, a nuclear deal with Iran, which could bring additional supply to the market, being delayed, and alternative sources like Venezuela still under U.S. sanctions, oil prices may remain elevated until either energy production ramps up or markets experience a form of “demand destruction” with consumers pulling back as gasoline prices become prohibitive.  

While Europe seems unlikely to support targeted sanction against Russian energy due to its high level of dependence, the U.S. may decide to go it alone and choose to stop buying Russian energy outright. Such a decision would certainly have some effect with the U.S. importing approximately 3% of its crude oil from Russia, but it may be more of a symbolic move than an impactful move with the U.S. still serving as the top oil producer in the world in 2021 and the bulk of its crude oil imports (over 60%) coming from its northern neighbor – Canada (see figures 2 and 3).

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At the very least, rising food and energy prices will likely sustain higher U.S. inflation over the next few months – potentially peaking at a year-on-year rate of 8.5% – a full percentage point higher than it stands today. This uptrend should keep the Federal Reserve on track to raise interest rates by at least 25 basis points (or 0.25%) at its upcoming March 15 and 16 Federal Open Market Committee (FOMC) meeting. Perhaps the Fed eventually takes a pause on raising rates should supply chain issues become more pronounced as a result of the Russia/Ukraine conflict, but for now, the Fed seems undeterred. This provides yet another headwind to risk assets with the Fed embarking on a new monetary tightening cycle into a potential global supply shock and a moderating global economy (see figure 4). It is not our base case that this will lead to a U.S. recession, but we think investors would be wise to at least acknowledge the rising risk and to ensure that their portfolio remains well-balanced and diversified.

This chart shows the OECD Leading Indicators for Major Economies

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Portfolio Shifts in a Changing World

Over the next few weeks and potentially months, Citi’s Global Investment Committee will continue to monitor global developments and make changes to its asset class recommendations as needed. Not only in terms of de-risking in certain segments of financial markets if warranted, but also to find potential opportunities that may arise as a result. At our most recent meeting, the Committee decided to add a 4% portfolio position in natural resources stocks with the allocation divided between the world’s largest commodity producing industries (energy, agriculture, metals, etc.) and oil field services. We also reinstated a 2% portfolio overweight to gold. These overweights were largely funded by portfolio reductions in European and Japanese stocks.

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