This view is shared by UK, US and EU officials who have been keen to keep sanctions relief off the agenda amid peace talks. Although recent actions have been met with scepticism in some quarters, markets have responded positively to reports of a de-escalation of Russian military operations (notably around the Ukrainian capital Kyiv) and agreed ceasefires to allow for humanitarian corridors to evacuate civilians from conflict zones. Any de-escalation in practice would be a welcome development and could bring a short-term reprieve to equity markets, but not necessarily to the global economy.
How should investors respond?
Moving forward, the key variable to watch will be inflation – what is driving it, and how are central banks responding. The risk of policy error remains real, amid further possible near-term shocks, and with multiple and competing data points feeding into decision making.
In a world of elevated inflation, historically, gold and raw materials have outperformed. However, given how far raw material prices have run to date – in March, Brent Crude reached its highest levels since mid-2008, and the wider Refinitiv CRB Commodities Index reached highs not seen in over 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.
Let’s not forget that one of the key consequences of the Russia-Ukraine conflict is likely to be the repricing of geopolitical risk. 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. 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.
In such a scenario, we would expect Europe and the Emerging Markets to underperform the US, but constituent markets could react differently. Emerging Markets are not a homogeneous asset class and we have to distinguish between countries. Those that depend on raw material imports, such as India, will be negatively impacted if the conflict endures.
Alternatively, countries exporting raw materials, and those that have relatively healthy balance sheets (where ‘relative’ is the key consideration), such as South Africa and the Middle East, would likely outperform in the event of a protracted conflict, in our opinion. In a scenario where the conflict is resolved in the near term – and inflationary pressures have not had time to impact demand permanently, and push the global economy into a recession – we would expect the US equity market to look comparatively less attractive versus the rest of the world given the higher valuations.
2022 is shaping up to be a very unpredictable year. Faced with binary outcomes, there are three key ways investors could look to insulate themselves:
- Maintain a diversified portfolio
- Stay selective and focus on companies that can better deal with cost pressure and have solid balance sheets
- Within equities, favour long-term themes that should continue to prevail, independent of the near-term outcomes. For example, infrastructure and the low-carbon ecosystem.
In the near term – with rising geopolitical tensions contributing to an already uncertain backdrop, lockdowns in China raising concerns about weakening output and demand, persistent inflationary pressures challenging central banks, and rising prices starting to weigh on household budgets – markets are perhaps being too complacent in the face of growing risks. The answer, for us, is to stay selective and stay diversified.
