The ongoing conflict in Ukraine poses many uncertainties, but even a resolution to the crisis would not be a silver bullet for markets.
Fabiana Fedeli, chief investment officer, equities and multi asset at M&G Investments believes investors are being too complacent about the risks ahead and should “exercise caution” in their equities exposure.
Equity markets have rallied since early March, with the MSCI AC World Index down less than 6% in US dollar terms year-to-date.
It has been a tumultuous year for markets in the first quarter; high, persistent inflation, a broad sell-off, and Russia’s invasion of Ukraine at the end of February.
Prior to the conflict in Ukraine, outlook for global demand and economic growth remained bullish.
“The case for equities was not as strong as in early 2021, but the asset class was still attractive, in our view, from a relative valuation perspective,” said Fedeli.
She added that the market volatility in early 2022 represented a buying opportunity, with significant price dislocations across the board.
“Given companies’ varying exposure to cost inflation and yield pressure on the balance sheet, selectivity was the name of the game.”
Binary outcomes
Fedeli said from a macroeconomic standpoint, the outcome from current events is likely to be a binary, either the conflict persists or there is an early resolution.
“If the conflict persists, we may be facing an inflationary spiral, which could weigh on the global economy – with elevated raw material prices feeding through the supply chain and curbing demand,” she said.
As well as compounding supply-side issues, fledgling demand will also persist throughout the year.
Fedeli said that firms have cited weakening sentiment as a driver of reduced sales volumes and increased pressure on consumer spending is unlikely to abate that.
The chairman of Taiwan Semiconductor Manufacturing Company (TSMC) also commented last week that the company was seeing signs of a slowdown in consumer electronics demand amid geopolitical uncertainties and lockdowns in China.
Looking at weekly gasoline demand in the US – is demand faltering there too?
In the graph, the green shaded area represents the pre-Covid five-year range and the pink line the average.
Year-to-date US gasoline demand, represented by the dark blue line, shows there has been a downward trend as gasoline prices have risen in recent weeks – above the peak prices reached in mid-2008.
If the conflict persists, energy prices are likely to remain elevated, further eating into consumers’ incomes,” said Fedeli.
“The announcement of a further release of US oil reserves on 31 March may have a short-term impact on oil prices but it is unlikely to have a longer-term impact given the temporary nature of the supply.”
The Biden administration is encouraging the US shale industry to drill more, but it takes a while to physically bring production onstream.
Therefore, it is unlikely that higher US supply will come on stream before Q4 2022.
Inflation the watchword for markets
The key variable to watch will be inflation, said Fedeli, and crucially, how central banks respond.
“The risk of policy error remains real, amid further possible near-term shocks, and with multiple and competing data points feeding into decision making.”
Historically, inflation has led to outperformance in traditional hedges such as gold and raw materials.
However, events at the end of February pushed the price of raw materials higher and in March, Brent Crude reached its highest levels since mid-2008, and the wider Refinitiv CRB Commodities Index reached highs not seen in a decade.
“A resolution to the conflict could see a steep decline in commodity prices from current levels, although possibly still elevated versus pre-conflict levels depending on the duration of sanctions and how long geopolitical concerns will remain in place,” she added.
“As central banks globally attempt to tame inflation and price pressure leads to further demand destruction, the risk of stagflation and/or a recession increases.
“In a recession, equities tend to underperform and, in that context, we would expect the US equity market to outperform on a regional basis, given the perception that it offers higher quality and greater defensiveness, and is also supported by flows of capital towards the US dollar.”
