By François Rimeu, Senior Strategist, La Française AM
At the time of writing, Russia has initiated military operations in Ukraine, not only in the separatist areas in the east, but also in other regions close to Kiev. Until Thursday, Feb.25, there was hope that the conflict could be managed with light sanctions on Russia: This is no longer the case.
We are not experts in geopolitical insights or forecasts and therefore will not speculate on the likely outcome of the conflict. Rather, we will focus on what we know about the current situation, and formulate assumptions, in order to consider the potential consequences of the conflict on financial markets.
The Russia-Ukraine conflict raises major risks, including namely a long-term and escalating energy crisis in Europe. Rising tensions could affect the European economy via energy markets, especially natural gas. Russia is Europe’s largest provider of natural gas, supplying 30 to 40% of Europe’s annual demand. However, more recently, the share of natural gas supplied by Russian has decreased significantly, because European countries have shifted their consumption from natural gas to liquefied natural gas, supplied by the USA and Qatar. Rising natural gas prices should affect overall demand in Europe, even if government support schemes will likely cushion the negative effect.
Other commodity markets could also be impacted, especially those for which Russia is amongst the largest producers: i.e. Nickel, Palladium, Uranium and fertilizers. In this case, inflation would be under even more pressure with higher food prices, higher semiconductor prices and so on. However, it does not mean that all basic trade between Russia and Europe would come to a halt. For example, since WWII, and even during the Cold War, trade relations have always existed. Nevertheless, it is likely that the Russia-Ukraine conflict leads to a commodity risk premium.
Centrals banks will be faced with a dilemma and forced to choose between two options, which could each have negative economic effects. The first option would be to respect their mandates, hence maintaining their credibility and continuing the tightening of monetary policy in order to fight against rising inflation. With consumer demand potentially under pressure, this could prove to be a difficult option which could have negative growth effects. The second option would be to delay rate hikes until the situation settles down, which implies running the risk of inflation becoming entrenched.
In our opinion, as of now, we do not expect geopolitical risk to stop the Federal Open Market Committee from hiking rates steadily by 25bp at each its upcoming meetings. Additionally, we believe that geopolitical uncertainty lowers the odds of a 50bp hike in March.
The European Central Bank (ECB) might be in a different position. The crisis could have a stronger negative effect on European growth than on US growth, and inflation is not as broad based as it in the US. More specifically, the job market does not seem as tight as in Europe with wages inflation at only 1.5% YoY during Q4 2021 whereas in the US, the Atlanta wages growth tracker was at 5.1%. Yesterday, ECB policymaker Robert Holzmann declared that the “Ukraine conflict may delay stimulus exit” which is an indication that the ECB is willing to adopt a less restrictive stance if necessary.
Consequences on financials markets are obviously dependant on the evolution on the conflict, so we have made some assumptions: Heavy sanctions on Russia and a major long-term energy crisis in Europe will be avoided. We will assume that the situation remains very stressed, with a fragile equilibrium between Russia and NATO, at least for the time being.
We must also consider what history has taught us. There have been several geopolitical events in the past which provide valuable insight as to how to navigate in this environment. In terms of market timing, empirical evidence shows that military invasions almost always constitute buying opportunities, as opposed to selling, for equities. This observation could be less valid in the case of a conflict which leads to higher energy prices.
Taking into consideration all of the above, we would argue against massive risk reduction. Equity markets will probably experience major volatility. A violent reversal, up or down, could occur in the coming days, making investment decisions difficult.
This should not be interpreted as a very positive view on risky assets over the medium term. Inflation is still trending higher, pushing central banks to adopt more restrictive policies. We believe there is a possibility that demand could disappoint over the medium term. That being said and against the backdrop of high commodity prices, we have a positive medium-term stance on energy and basic materials stocks and maintain a flattening bias in our fixed income portfolios.
Disclaimer
This commentary is intended for non-professional investors within the meaning of MiFID II. It is provided for informational and educational purposes only and is not intended to serve as a forecast, research product or investment advice and should not be construed as such. It may not constitute investment advice or an offer, invitation or recommendation to invest in particular investments or to adopt any investment strategy. Past performance is not indicative of future performance. The opinions expressed by La Française Group are based on current market conditions and are subject to change without notice. These opinions may differ from those of other investment professionals. Published by La Française AM Finance Services, head office located at 128 boulevard Raspail, 75006 Paris, France, a company regulated by the Autorité de Contrôle Prudentiel as an investment services provider, no. 18673 X, a subsidiary of La Française. La Française Asset Management was approved by the AMF under no. GP97076 on 1 July 1997.