The Russian invasion of Ukraine is negative for the global economy primarily as a result of the disruption in the supply of energy and other commodities. This comes before we have corrected all the supply issues related to COVID. The policy response to the pandemic was positive for markets, it is not clear how policy can replicate a positive response in this case. It may need to be more defensive. It could be that central banks have to adjust their interest rate pathway. This would delay any further rise in bond yields and offer some support to equity markets that are likely to have to deal with earnings downgrades.
Impaired economic outlook
Some of the comments from Russian President Vladimir Putin have been chilling. Whether they constitute a realistic threat to escalate even further his military adventurism is difficult to assess. However, for investors they serve as a warning that there is a scenario in which events could get even worse in terms of their implications for the global economic outlook and financial markets. At the moment what we observe is a negative shock to the world economy coming from the further increase in global energy prices. This will cut into growth and add to inflation. As such, global forecasts for GDP will need to be revised down and markets are having to reassess their expectations for the path of interest rates, credit risk and corporate earnings.
The immediate threat from what is happening in energy markets is that high natural gas prices will be a huge dampener on economic growth in Europe. At the same time, rising crude oil prices will impact on the US consumer. A sobering observation is that every US recession in recent times has been preceded or accompanied by a sharp rise in oil prices. The good news, maybe, is that in real terms (compared to broad non-energy and food inflation), oil prices are still well below the peak they reached in 2006-7. Moreover, the US economy is probably somewhat less prone to weakness related to rising oil prices than it has been in the past. Nevertheless, the sharp rise in nominal gasoline prices together with generally higher rates of inflation is not good for already shaken consumer confidence.
Can central banks deliver all those rate hikes now?
All of this creates a more difficult outlook for central banks and the path of interest rates. There are still six Fed rate moves priced in for this year although the narrative has started to be tainted by the possibility that there will need to be a more cautious approach given the growth risks. The observation I made recently regarding the shape of the yield curve still holds. The curve is flat and has flattened further in recent days. There is no pricing in of a significant and sustained increase in long-term bond yields in most currency areas. Bond yields are off their highs. Until there is more clarity on how the war progresses, I doubt we will see new highs unless the message from central banks is clearly that their only focus is on controlling inflation. That would be a tough position to take in a global political crisis with clear downside economic risks. It is noticeable that real yields in the US fell back sharply on Thursday, providing some relief to the equity market and perhaps indicating a shift in market expectations about how far monetary conditions can be tightened.
Part of the complex view for bond markets is working out where the tipping point is regarding inflation. Higher inflation will undermine growth in real income and raise medium-term recession risks. If central banks react aggressively to a supply-side led rise in inflation, those recession risks become more material. Aggressive balance sheet reduction does not seem appropriate in that environment and there may be calls again for more fiscal action to alleviate the negative income effects of the energy price shock. There will be no inflation if central banks kill the economy and, at any rate, higher interest rates don’t lead to an increase in the supply of gas and oil.
Fair-value in equities depends on earnings
If bond yields remain low what should we think about equities? I have very simple valuation metric that looks at the relatively recent relationship between price-to-earnings ratios and bond yields. If the consensus 12-month out forecast for S&P500 earnings-per-share remains where it is, at $227 per share, and bond yields remain below 2%, the equity market is at “fair-value” at an index level of around 4170, around 2.8% lower than the close on 24 February. For other markets, like the FTSE350 and the Euro Stoxx indices, current market levels are very close to fair-value using this simple approach. However, the big unknown is whether those 12-month out earnings numbers can stay where they are. A 10% reduction in earnings forecasts would suggest that levels below 4,000 on the S&P are justified.
Downward revisions likely
So the decision whether to turn more positive on equity markets depends on the balance between more attractive valuations and the risk to aggregate earnings growth. The longer the war goes on and the longer energy and other markets remain stressed, the greater risk of lower earnings and the more downside risk there is to markets. In that bearish scenario, bond yields will likely move lower again, pushing real yields back towards the lows seen last year. In the coming days and weeks, the key signals will come from what is happening on the ground in Ukraine, how Russia’s strategy unfolds, when and if it manages to take control of Donbas, and what further retaliatory steps are taken by the international community.
Sanctions are complex
So far sanctions have not involved a decision to stop buying Russian gas supplies or removing Russia from the SWIFT payments infrastructure. There is an obvious reason for the first as Europe depends significantly on Russian gas. Removing Russia from SWIFT would halt a huge amount of international transfers with Russia including payments for commodities – which would then clearly have an impact on western economic growth. It would also reduce Russia’s ability and willingness to service its foreign currency debt, effectively causing a default. After falling sharply in price in the wake of the invasion, Russian debt currently accounts for a small weight in most emerging market bond indices. Holders have taken a huge hit already - around 50% in total return terms. An escalation of the financial sanctions does not risk a Lehman-type threat to the global financial system but there will be repercussions that central banks and other authorities will need to address if they materialize. I am sure that the announcement of “bazooka” style sanctions will have a short-term negative impact on risk assets but assessing their longer-term impact on the global economy will be complex.
Another issue for investors is how to deal with the current situation through the lens of sustainability. Most ESG policies are focused on corporates and attempts to bring sovereign debt into an ESG framework are less advanced. Yet if we think about the failure of engagement (diplomacy) and the impact of Russia’s actions (on people, on the environment and in terms of governance) then surely there is an argument for considering action that may go beyond what is dictated to by official sanctions. It is a difficult issue as numerous countries could be considered as “bad” investments given issues like commitment to net-zero, respect of international law and human rights. Hopefully, in this case, pressure from ordinary Russians and the majority of the international community, combined with the bravery and stoicism of the Ukrainian people, will result in Russia failing to achieve its political ambitions and pave the way for a different future for that country. For now, let’s hope peace comes quickly.