The Big Picture
The events in Ukraine are unfolding rapidly. There has been tragedy and heartache for many. But, the goals of Russian President Vladimir Putin and ‘solution’ remain unclear.
We have neither the expertise to elaborate on the reasons for the Russian invasion or to speculate on how it might end. Naturally, our thoughts are with those who have suffered. We will focus our attention on what we need to consider just to analyse the impact on markets.
The extremes of possible outcomes seem to be many and varied: returning the Ukraine and possibly other countries to the ‘Soviet Bloc’; support for the Ukraine from outside of the region – both arms and troops; a protracted but failed attempt to ‘quell’ the Ukrainians; failure of Putin resulting in the end of his leadership.
Without capacity for fact checking, we are relying on news reports. Russian troops entered the Ukraine in the last week of February resulting in casualties on both sides. It has been widely reported that the Ukrainian resistance has been far stronger than most would have anticipated.
Germany has offered arms to the Ukraine in a big break with tradition. The usually independent Switzerland has joined the move for sanctions on Russia. Many other countries – including Australia, the US and UK – have offered support but there seems to have been no move yet to send troops in. NATO has been readying its defence forces in Latvia.
Russia has reportedly threatened Finland that it will get the same treatment if it attempts to follow the Ukraine in trying to join NATO. In some sense, this conflict has a parallel in the US objection to the Cuban missile crisis in 1962. The US repelled Soviet missiles on their doorstep in that encounter, and Russia might be trying a similar move now.
Although sport and the Eurovision song contest are unimportant when compared to these geopolitical issues, the Russian population might think lesser of Putin when they realise that they have lost the Russian F1 Grand Prix, the Champions League final, various Qatar World Cup (soccer) matches and participation at Eurovision.
Putin might have expected a quick resolution to his demands – whatever they might be – and claimed a big victory as he tries to install himself as a ‘lifetime president’. A protracted affair and losing face over international events might erode his popularity domestically to the extent that a new leadership regime might challenge him.
Unsurprisingly, stock markets fell in value as the invasion neared. What perhaps is surprising is that a rapid reversal started as rockets hit targets in Kyiv (formerly Kiev) – the capital of the Ukraine. It is often the case that bad news such as the rocket strike has a positive effect on markets. Investors and traders might have thought it could have been a lot worse: war could be declared on Russia by the West; or the Ukrainians could simply have surrendered. In other words, markets may have priced in far worse conditions and so this bad news was relatively good compared to expectations.
Since there may well be many more stages in this crisis, it is perhaps unwise to jump in and out of markets as events unfold. Prudent investors set a long-term asset allocation and change allocations in a considered fashion.
It has been reported that talks between Russia and the Ukraine have started. The first round concluded on the last day of February. Many groups in the West – both private and government – having been expressing support for the Ukraine. China has not played its hand yet. One big worry is that, if Russia manages to annex the Ukraine easily, China may be emboldened by the apparent success of the Russian action and may initiate its policy for the re-unification of Taiwan.
There are some clear economic concerns that follow from the conflict. Oil and gas prices rose sharply because Europe’s access to Russian resources were reduced. On top of that, a major oil installation in the Ukraine has been damaged or destroyed. Major oil companies are exiting Russia. Energy prices have been a major source of inflation in western consumer price indexes over the last 12 to 18 months. This conflict can only exacerbate that situation.
The Ukraine and Russia have been supplying a significant amount of grain – notably wheat – to the rest of the world. Food prices will rise as a consequence of limited access to exports.
SWIFT, a global method for settling accounts between banks, is said to be being turned off for some Russian banks. While this would hurt the Russians more, there might be some fall-out to the rest of the world.
A number of high-profile Russians – the so-called oligarchs and highly-ranked officials – are having sanctions placed on them. Air space for Russian aircraft has been limited.
It is difficult to total up the consequences that might follow the invasion. It must have a negative impact on the world but – as with other recent conflicts notably in the Middle East – economic life has gone on for us in the West.
Naturally we wish for a speedy and safe resolution of the conflict. But one thing is certain – raising interest rates in the US, Australia or most other places will have no impact in reducing inflation in food and energy prices resulting from this crisis or from the run-up due to the pandemic.
Before the start of the conflict, pressure was building for various central banks, including our own (RBA), to raise rates to counter inflation. The CME Fedwatch tool that prices expected rate hikes in the US by the Federal Reserve (“Fed”) had placed a 33% probability on there being two hikes at the mid-March meeting. The Bank of England just hiked rates for the second time and New Zealand hiked for a third.
The latest inflation data for the US were quite high – 7.5% for the CPI and 5.2% for the Fed’s preferred “core” PCE inflation that strips volatile energy and food prices out of the calculation.
The probability for a double hike in March was cut from 33% to 6.6% on the outbreak of hostilities in the Ukraine. People are understandably worried that an aggressive Fed would only compound any knock-on effects from the conflict. Caution is warranted!
Interestingly, wage inflation in the US is starting to become an issue. The latest annual wage inflation reading was 5.7%. While that rate is very high, it is about the same or lower than the price inflation data coming through. Workers are not, on average, feeling any increase in so-called real wages.
The reasons for wage inflation are quite well known. Lots of people don’t want to go back to their old jobs either because of the pandemic or because they prefer the lifestyle of working from home. They are having to be paid more to turn up to work! It is important to note that there are 2.9 million less people employed in the US compared to January 2020 when the pandemic was just getting underway. The current situation is not due to new demand but the existence of supply constraints.
Whether or not there are one or two hikes in the US in March, the CME Fedwatch tool sees the funds rate approaching 2% or just above by the end of the year. Conventional wisdom in economics is that monetary policy takes about 18 months to two years to take effect in the real economy. Therefore, if we do see the start of a return to normal ‘neutral rate’ inflation this year, it is likely not due to rate hikes but an improvement in supply-chain blockages and a possible fall in energy prices.
In Australia, we do not have an inflation problem. The RBA’s preferred ‘trimmed mean’ estimate came in at 2.6% which is in the middle of its target range. Wage inflation came in at 2.3% for the year. The reason for the difference between Australia and the rest of the developed world is not easily explained. But, if we don’t have a problem, it seems counter-productive to us in this uncertain world to raise rates for the sake of it.
Our latest jobs data showed the unemployment rate staying at a low 4.2% with 12,900 jobs having been created and that is for an Omicron-affected month of January!
The RBA has kept rates on hold but ended “QE” – the bond-buying programme designed to keep longer term rates down. It has clearly stated that it is in no rush to raise rates although some economists disagree. We expect at best a modest increase in rates this year.
In our opinion, the recent company reporting season in the US has resulted in stronger expectations for future earnings. As a result, we see a return to growth in the S&P 500 once the Ukraine situation is resolved or, at least, ceases to escalate.
Energy (+5.8%) and Staples (+5.6%) stocks in the ASX 200 performed strongly over February but the broader index was only modestly up (+1.1%). The sell-off at the end of February makes stocks relatively cheap providing the Ukraine crisis has no major lasting economic cost.
Company reporting season has not bolstered expectations for the broader market. Worries of the impact of Omicron and more recently the Ukraine crisis have dampened forward expectations. However, we still expect about an average capital gain on the index over the whole of 2022.
Most major markets were down sharply over February but the result would have been a lot worse had it not been for a sharp bounce back following the rocket attacks on Kyiv. At one point, the S&P 500 was firmly in correction territory having fallen more than 10% from the recent high.
Wall Street had a largely positive company reporting season with the exception of a few mega-cap tech stocks such as Meta (formerly Facebook). Our calculations imply that 2022 might produce an above average gain in the S&P500 so long as the Ukraine crisis does not spill over into a major economic loss for the global economy.
Bonds and Interest Rates
The US bond market moved quite sharply over February on expectations of an aggressive Fed (rates rising) and then rates fell away as the Ukraine crisis unfolded later in eh month. Yields are higher across the full range of terms on bonds.
One member of the Fed committee, Jim Bullard, has been saying publicly that the Fed should have started hiking rates last year before ‘inflation started to get out of control’. He has a reputation for speaking out in this fashion and we do not give much credence to his view. Most of the inflation in the US was caused by things not sensitive to interest rates – like the energy price spiral and supply-chain bottlenecks.
The RBA – since it has previously stated that it is in no hurry to raise rates – is unlikely to do anything until peace returns in Ukraine. If there is a swift resolution to the crisis, the RBA might raise rates from the historically low 0.1% to 0.25% around mid-year with the prospect of an additional one or two full 0.25% increases later in the year.
The price of Brent Oil – the representative world price of oil – rose sharply (+10.6%) to over $100 per barrel in February. With the exacerbation of oil supply issues following Ukraine, there is little hope for a return to longer term price levels in the near term.
The price of iron ore has retreated a little to $137 per tonne from its $150 per tonne peak in February. The prices of gold (+6.0%) and copper (+3.5%) were modestly up over February.
The $A gained against the $US and was up from just above 70 cents to 71.8 cents over February but the big four banks are each predicting a much stronger $A over the rest of the year to between 75 and 80 cents. While such a rise would mark a return to long term levels, we struggle to support that view if the Fed hikes rates aggressively and we do not. It would take a big gain in China growth to achieve an exchange rate of 80 cents in our opinion.
Retail sales for the year were down 4.4% as Omicron disrupted spending patterns. Households have accumulated about $260 Bn of savings over the pandemic so that, when they are ready, they can start spending again.
Australian employment is up about 2% over the two years since the pandemic began. Contrast this gain with the loss of 2.9 million jobs in the US over the same period. The RBA, however, thinks we remain short of what they think of as ‘full employment’.
China has been unnervingly quiet about the Russian invasion of the Ukraine. Indeed, initially it could not bring itself to use the word ‘invasion’.
There is some suggestion that China is ready to start stimulating its economy again. It did make a modest cut to one of its official interest rates. The property debt problem seems to have largely blown over.
There was a very big beat in jobs last month. 467,000 jobs were created when only 150,000 were expected. Moreover, the previous two months of data were revised upwards by 709,000. The unemployment rate came in at 4.0% when 3.9% had been expected. The wage rate increase came in at 0.7% for the month or 5.7% for the year. GDP growth for Q4, 2021 was revised upwards to 7.0%
Inflation is a problem and it is becoming stubbornly high. It is taking quite a while for supply-chain bottlenecks to be removed.
Biden’s popularity has been sagging since his term began. He does not seem to be making any political capital out of the Ukraine situation. It is hard to forget his words when he said the US would tolerate ‘a little incursion but not an invasion’. Russia seems to have ignored him.
All of the action in February was in Eastern Europe. There was an initial meeting between Russia and the Ukraine on the border with Belarus. That failed to achieve a resolution. Further talks are being considered.
Finland has been warned by Russia to not consider joining NATO and neighbouring countries must be nervous about whether this is the start of a plan to reconstitute the failed former Soviet Union.
Putin is said in some circles to bring back the golden era of the Russian Empire but he also looks like a leader who might have lost the plot.
EU inflation came in at 5.1% and that in the UK at 5%. The Bank of England has already hiked rates twice.
Rest of the world
The Russian rouble depreciated by 28% on news of sanctions by the West against Russia. The Russian Central Bank more than doubled its reference rate from 9.5% to 20% in response.
New Zealand delivered a third successive interest rate hike on the run at its latest meeting.
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