Ukraine crisis and renewed volatility: What investors need to know
Volatility returned to markets on 24 February 2022 - Russia's invasion of Ukraine poses several global risks. Generally speaking, geopolitical crises impact markets mainly through three channels that we monitor and share our analysis:
- Growth and inflation
- Central banks' reaction to the pre-crisis scenario
- The uncertainty around all these parameters, which increases the risk premiums demanded by investors
- Growth and inflation. The first channel plays directly on earnings growth expectations for equities, default rates for credit and inflation expectations for nominal bonds. The greater the impact on growth, the greater the likely fall in risky assets to adjust to the new growth and default risk scenario.
- Central banks. The second channel, the impact of the crisis on monetary policy, is affecting expectations of policy rates and asset purchases by central banks. This has a direct impact on nominal bonds as well as on equities whose valuations are highly sensitive to interest rates and on asset purchases (quantitative easing), which tend to lower risk premiums.
- Uncertainty increases the risk premiums demanded by investors. The third channel, uncertainty over all these parameters, directly impacts risky assets through an increase in the risk premium that weighs on asset valuations such as equities or high yield credit. If the impact of the crisis on fundamentals is rapidly assessed by the market and central banks communicate clearly and quickly their intentions, risk premiums can potentially rapidly decrease.
What is the prospect of a market rebound?
Historically, the impact of geopolitical crises on markets has been rather short-lived. While past performance should not be seen as a guide to future returns, in many previous cases, within 30 days of the initial shock, much or all of what was lost was regained by markets. On average, the loss to equities in historic examples is less than 10%1 , with the exception of a few emblematic cases, such as Iraq's invasion of Kuwait in 1990 or the subsequent oil embargo and oil shock, which led to recession in the developed world. Ultimately, much depends on the strength and duration of the expected shock to the economy, the economic context that prevailed before the shock, and the response of monetary and fiscal policies.
Commodities, GDP and valuations
The main channel for broader market contagion of the current crisis is via commodities prices, with Russia representing a very low share of exports from developed economies, as well as uncertainty about the rise in commodity prices and its impact on growth, inflation and monetary policy. From this perspective, the risk of a major growth shock remains limited, in our view. Even if the price of a barrel of Brent crude oil reached $125, growth is expected to remain above potential in both the US and Europe, with a cumulative cost in 2022 and 2023 for the Eurozone of 0.9% of GDP2 in this scenario. The impact on the US would also be relatively limited. At the same time, monetary policy expectations have adjusted, with a notable decline in Federal Reserve (Fed) and European Central Bank rate hike expectations this year. On Monday 28 February and Tuesday 1 March alone, the market adjusted to price in 1.5 fewer Fed rate hikes. These changes in expectations led to a steep drop in real rates, which is typically a support for US equity valuations, in particular.
However, uncertainty - particularly about the retaliatory measures Russia could implement, via a reduction in its oil and natural gas exports - continues to maintain risk premiums at high levels, impacting the valuation levels of risky asset classes. However, we believe some of this risk is already priced into commodity markets. The price of a barrel of Brent has risen by more than 40%3 since the beginning of the year, driven by worries about disruptions and the lack of a counter reaction from OPEC (for now). Meanwhile, the price of European natural gas has risen by 157%4 since the beginning of the year.
This dramatic context comes at a time when economic activity is showing signs of re-acceleration in developed economies, as shown by the latest Purchasing Managers’ Indices company survey data. This improvement is supported by the ebbing Omicron wave and a very gradual resolution of supply problems, which we believe should continue to support economic activity in the first half of the year. This should mitigate the market impact of the current crisis and, in our view, should eventually trigger a rebound. We therefore remain constructive on risk assets over the medium term.
The role of multi-asset management in this context
We use our flexibility to seek to protect portfolios in this turbulent environment, reducing our exposure to Eurozone financials (in particular European banks) and extending duration. We reduced our exposure to Europe to re-expose ourselves to the US, which we believe should be less impacted. Of course, we continue to monitor the situation very closely to adjust our allocation in line with current events and our convictions.
- AXA IM, 28 February 2022
- AXA IM Macro Research, 25 February 2022
- Bloomberg, 2 March 2022
- ICE Natural Gas Future, Bloomberg, 3 March 2022