09 March, 2022

Confidence in Our Positioning Despite Challenges

Equity Markets

The war in Ukraine presents a number of questions about the near and long-term outlook for the global economy and markets. 

Our Portfolio Management Team has been tackling some of these important questions since the beginning of Russia’s invasion. 

We must first realize that this is a regional conflict with big, global consequences. The impact on the global economy will be shaped by the war’s political and geopolitical legacy. These are big questions that are impossible to answer with any certainty, however we have some views that might help provide perspective. Let’s start with current market conditions.

We are seeing some strains in markets since the invasion of Ukraine, but no panic yet. While Russia’s financial markets have unraveled, global markets have, so far, held up relatively well. But, the mood seems to have turned a bit in recent days, and there are now some early signs of financial stress beyond Russia’s borders.

Conditions in Russia’s financial markets have deteriorated sharply, and the country faces its worst banking and financial crisis since the 1998 sovereign default. Trading in many assets is limited, if not outright prohibited, and the prices of those assets that are tradeable have generally fallen by enormous amounts amid thin liquidity and dramatic volatility. In contrast,

global financial markets have, for the most part, taken the war and the initial economic fallout from it in stride: markets are down but we haven’t seen panic selling, and fixed-income markets have remained stable.

Commodity prices have risen sharply, and volatility has picked up across bond, equity, and currency markets. Bond and short-term rates markets are experiencing sharp swings.

Our sense is that investors are not yet bracing for a financial crisis outside of Russia. Instead, we think most of the sharp market shifts over the past week simply reflect the extreme uncertainty generated by a war involving a nuclear power and major energy exporter. In addition, there is the growing risk of a stagflation environment in which inflation picks up even more and growth slows. The situation is evolving rapidly, and it’s possible that market conditions could get worse before they get better.

Sanctions are being imposed on Russia’s energy exports by the U.S. and the U.K., but the devil is in the details.

The economic and financial market impact will only become clear when we know the scale and timing of sanctions.

It appears, for now, that energy sanctions that target oil, natural gas and coal will just be a U.S. initiative while the U.K. restrictions will phase out imports of Russian oil and oil products by the end of 2022. European customers of Russian energy would need to be given time to find new suppliers (as happened when sanctions were imposed on Iran).

Our view is that an outright ban on all Russian energy imports would cause the prices of Brent crude oil and European natural gas to increase an additional 35%+ in the near term (prices are already up nearly 80%!) and settle at still very high levels into next year. The Russian economy would contract by as much as 25%, causing sovereign and corporate default risks to crystallize. Inflation in advanced economies would end the year at around 5% as opposed to the expected 2.5% prior to the invasion, and the effects of the drop in households’ spending power – combined with power rationing in Europe – would push the eurozone into recession.

As for the rest of the world, this scenario would see inflation staying higher for longer, likely twice our pre-invasion end-year expectation. Higher energy prices are also boosting the prices of agricultural commodities and industrial metals.

The war in Ukraine is challenging our asset allocation views. The situation is fluid, and the outlook is especially uncertain, but here are our initial thoughts on how things may play out for global financial markets from here.

Listen in as I discuss how the situation in Ukraine has affected our portfolio positioning with VP, Business Development, David Nicholson.

We thought that most commodity prices would fall significantly by the end of 2022. We forecasted that crude oil prices would drop by the end of this year as growth in demand cooled and supply recovered. We also expected the prices of other energy commodities to decline, and that the associated fall in production costs would send prices of metals and agricultural commodities lower, too, as crude prices fell and supply chains repaired themselves “post Covid”. This call has clearly not gone our way in the last three weeks, however, most of our portfolios remain overweight Canadian equities and have benefited from the global macro conditions. Where prices go from here will depend upon the course of the conflict and the extent to which Russia’s economic relationship with the West fractures further.

We had expectations that equities would outperform bonds this year, as global central banks raised interest rates and most economies kept on growing.

Both bonds and equities have been quite volatile, but bond yields have fallen as investors have sought out safe havens. Investor expectations have shifted with the onset of the conflict that central banks will scale back their plans to raise interest rates, even though the shock to commodities is set to put upward pressure on prices, at least in the near term.

In more normal times, central banks might look through higher inflation resulting from a shock such as this, but with inflation already high in most places, and some policymakers clearly concerned about inflation expectations becoming unanchored, we doubt that central banks will substantially scale back their plans to tighten. The bar to do so seems to be set very high.

If the fallout for the global economy is limited, we suspect that most stock markets could still make small gains over the rest of 2022.

But, with valuations still high in some places, bond yields, in our view, are more likely to rise than fall and, with uncertainty elevated, big rises in yields seem unlikely. A quick resolution to the war may also not be good for equities if it means that interest rates rise sharply again, similar to earlier this year. The worst outcome for stock markets would be a scenario in which an escalation of this crisis means a more significant economic hit, weaker earnings growth, larger risk premia required by equity investors, and much higher bond yields as central banks still feel the need to respond forcefully to high inflation.

Our view of the relative performance of sectors and geographies is also being challenged. From February 15 - 23, Technology (IT) and other “tech-heavy” sectors such as Consumer Discretionary and Communications Services had the worst performance of any global sectors, continuing a theme of early 2022. But, between February 23 and March 3, the IT sector was the top performer, boosted by falling bond yields. This IT outperformance has reversed itself through to March 7, but the point is that the outperformance of Financials and other cyclical stocks is not a given. These sector patterns also partly explain why U.S. equities have outperformed most other developed market equities since the invasion, but Europe’s dependence on Russia for energy imports is also a factor. This all challenges our view that U.S. equities would underperform other developed market equities. If you recall, we have a small overweight to international equities, which has been a negative contributor since the start of the conflict. But despite the effect of the war and the associated sanction on the European region’s economy, we don’t expect the post-pandemic recovery to be derailed.

How these patterns evolve from here will depend on the conflict, its impact on commodity prices, and bond yields.

If commodity prices drift lower and bond yields resume their climb, these recent trends would presumably reverse, at least in part.

But there is surely a growing risk that many of them are sustained. As we indicated earlier the situation is evolving rapidly, and there is clearly a lot of room for market conditions to get worse before they get better. We will continue to evolve our views and positioning as conditions warrant, but for now we believe that we are positioned appropriately.

Until next time, stay safe and be well.

Corrado Tiralongo
Chief Investment Officer
Counsel Portfolio Services | IPC Private Wealth