The situation in Ukraine overturns many assumptions about the recent direction of the global economy. "Black swan" events like this don't happen very often, but we're in the middle right now and things change every day.
For global equities, the key question is whether the conflict will lead to a recession in Europe. Historically, global stock markets have recovered and recorded gains after a period of conflict, unless a recession ensues. U.S. stock market investors are keeping a close eye on soaring energy prices and rising inflation, which typically hurt household spending. The U.S. household savings rate is already at its lowest point since 2013, providing consumers with little cushion.
Meanwhile, the Fed was in trouble at its March 15-16 meeting, and it was widely expected that the Fed would start raising interest rates. For months, the Fed has been signaling tighter monetary policy, and if it fails to follow through, it could lose credibility in fighting inflation. On the other hand, if it tightens its policies too much or too quickly, it could push the economy into recession.
The conflict is also a catalyst to end Washington's long-standing stalemate over the federal budget. More than $13 billion in aid to Ukraine was added to the massive government funding bill, and the bipartisan desire to provide aid to Ukraine quickly led to a massive spending deal that crossed congressional ultimate line.
Global Equities and the Economy: The Situation in Ukraine
The situation in Ukraine continues, with Europe being the main focus of investor attention as it is close to the conflict and dependent on Russian energy. This escalation increases the likelihood of further energy price inflation and recession in Europe.
In the long run, the long history of geopolitical events suggests that diversified investors may not need to take defensive action in their portfolios – unless we enter a recession. After the conflict of the past 30 years (1991, 2001, 2003, 2014), the stock market recovered and recorded gains, but the recession followed, except in 2008. These conflicts vary, but their economic backgrounds are similar and all involve major energy exporters. For example, the 1991 and 2001 conflicts preceded a recession. Before the conflict broke out in 2003, oil prices doubled. The economic sanctions against Russia were imposed in response to the situation in 2008 and 2014. When the Fed signaled a tightening halt before the conflict erupted in 2014, it triggered a "shrinking panic." This means that a key question for investors is: Will the current conflict lead to a recession?
In the wake of the Ukraine crisis, the European economy is currently being challenged by rising energy prices and tightening lending conditions. With or without sanctions, energy prices are likely to rise if global deliveries of Russian energy products are rejected in a de facto boycott. This can lead to higher costs for companies in many industries.
However, there are a number of factors that can reduce the likelihood of a recession:
The European economy strengthened in February as the economy rebounded from a micro-driven slowdown. Measured before the invasion, the Composite Purchasing Managers' Index (PMI) rose to 55.5 in February, a level consistent with the above-average growth rate of 2.6% in gross domestic product (GDP).
Uncertainty makes it less likely that the ECB will raise interest rates, meaning that current monetary policy remains unchanged. So far, financial conditions have tightened rapidly, but remain within the non-recessionary range of the past 10 years.
European governments are further increasing fiscal spending, as evidenced by an increase of 100 billion euros in German defense spending.
Constrained by the pandemic, European consumers are saving well above average, helping to mitigate the impact of rising energy prices on overall spending.
Europe has the largest consumption of natural gas and the greatest pressure on energy supply, which is falling seasonally as prices soar. The chart below shows the seasonal pattern of gas use in Europe over the past five years before the pandemic and how it fell by half from January/February to April/May.
As winter comes to an end, natural gas use in Europe declines seasonally
This escalation increases the likelihood of rising inflation and a recession in Europe. Any downgrade could lead to a relief from the rebound and the release of suppressed consumer demand. Maintaining a high degree of confidence in any particular outcome in the short term, for better or worse, can be challenging.
Fixed Income: Central banks are in trouble
The situation in Ukraine has led to two seemingly contradictory market reactions: rising inflation and falling bond yields. As sanctions against Russia reduced the flow of energy products, metals and grain streams to global markets, inflation rose sharply and commodity prices soared. However, the supply-side shocks caused by the crisis have simultaneously lowered growth expectations and boosted demand for safe-haven assets such as U.S. Treasuries. This puts the Fed and other major central banks in trouble.
Late last year, the Fed was surprised by the strong growth brought about by the pandemic and the rise in inflation due to the limited supply of goods. It was clear that the U.S. policy environment was too accommodative given economic strength, and the Fed said in December that it would shift to stricter policies in early 2022. Fed Chairman Jerome Powell said the committee wants to restore its policy setting to "neutral," a level suitable for stable economic growth without generating inflation. The Fed's long-term target for a neutral interest rate is 2.5 percent. Bond yields are rising in light of a series of interest rate hikes, with 10-year Treasury yields rising above 2%.
Ten-year Treasury yields have been rising
Now, we are in a different world and the global economic outlook is much weaker. High energy costs could tax consumers and reduce business investment in the long run. In addition, financial conditions are tightening against the backdrop of a stronger U.S. dollar and widening credit spreads as investors become more risk-averse. Tighter financial conditions tend to precede slower growth.
Financial conditions in the United States and Europe are rapidly tightening
Against this backdrop, the Fed is in a difficult position. If it fails to implement austerity, it could lose credibility in fighting inflation. On the other hand, if it tightens its policies too much, too quickly, it could push the economy into recession. In addition, in times of turmoil in global markets, policy will tighten, which could lead to slower economic growth and lower liquidity.
Markets have expressed skepticism about the Fed's ability to reach a "neutral interest rate." The implied path of short-term interest rates has changed over the past few weeks. The five-year forward short-term rate, which measures the expected inflation rate over a five-year period starting today, has fallen below the one-year forward rate. In the past, this happened near the peak of the Fed's tightening cycle, not before they started. Based on the futures market, fed rate hikes are expected to peak in 2023 and then fall.
The market expects the federal funds rate to peak in mid-2023
In addition, yield spreads between 10-year and two-year Treasuries have fallen to less than 25 basis points, below areas where policy tightening is usually too fast. Historically, yield curve inversions have been a reliable indicator of recession.
The yield curve flattens
The Fed does have a choice. It may announce a "dovish hike". In other words, it could move on to the 25 basis point hike widely anticipated on March 16, but said it was still assessing the way forward given the uncertainty caused by the war. It could also delay or slow the pace of its planned balance sheet reduction until the "fog of war" clears. However, this is a high-line behavior.
If the Fed says it is prepared to continue to tighten monetary policy significantly, we expect long-term yields to decline due to the risk of a recession triggered by the Fed's move. If the Fed takes a more cautious approach, long-term yields could rebound. The Fed and bond markets are now in a position to react to the Russian-Ukrainian war.
U.S. Equities and Economy: Contagious Energy
The escalation of the situation in Ukraine since the end of February – and the subsequent economic and financial chain reaction – has become a major driver of rapid market volatility. Volatility has soared in almost every asset class, and the rupture in the commodities space has triggered the latest discomfort.
Until Tuesday, when the United States announced it would ban Russian energy imports, Western sanctions on Russia had ruled out the energy sector, largely due to the high dependence of several European countries on Russian oil and gas. But Brent crude prices soared as investors priced the possibility of sanctions and supply disruptions. In fact, the price per barrel recently surged above 50% above the 200-day moving average, as shown in the chart below.
Oil prices and energy stocks soared
This is in line with the strong performance of the S&P 500 energy sector, which recently climbed to 30% above the 200-day moving average. Energy is currently the best performing sector, and the range is quite large.
While no other industry has come close to energy gains this year, it has been leading the way in factors across multiple industries. In fact, high-quality value factors, such as high yield yields and high revenue relative to price, have been among the best performing factors in the energy and technology sector this year. Although the energy sector has outperformed the tech sector by nearly 52 percent this year, the factor leadership of the two companies looks almost identical, confirming that investors can find stability without having to go all out.
High energy prices coupled with high inflation and rising inflation tend to dampen households' spending power. Although energy spending accounts for a smaller share of total consumption than it did during the global financial crisis, it still imposes a regressive tax on consumers, especially those at the lower end of the income and wealth spectrum.
Moreover, as the chart below shows, the savings rate has plummeted from the peak of the pandemic to its lowest level since 2013. As a result, households' buffers against inflation are weakening.
The pressure of low savings builds up
Looking ahead, there is some good news on the inflation side. In addition to the soaring energy prices, there are also signs of decline in other areas. Supply chain pressures, which have helped push prices up to decades-long highs, look like they are easing. As the chart below shows, the New York Fed's Global Supply Chain Stress Index has fallen sharply from its recent peak. The supplier delivery portion of the ISM PMI increased slightly, but both were far from peaking during the pandemic.
Freeze the thawing of the supply chain
Inflationary pressures plaguing the economy are likely to continue to be exacerbated by the current energy shock, with improvements under the surface and in several supply sectors supporting the prospect of a slowdown in inflation throughout the year. In addition, continued spikes in energy and food prices – which will keep headline inflation high – could put more downward pressure on demand for most other components of the traditional inflation index.