February 2022 Market Update – Russia’s Invasion of Ukraine Continues the Rocky Start to 2022
Despite a global economy which appears to be opening up and moving towards a sustainable post COVID-19 recovery it has been a rocky start to 2022 for investors around the globe. Some stockmarkets have fallen more than 10% from recent highs and bond yields in many countries have increased meaningfully in the past few months as investors are trying to navigate through a supply chain and energy led inflation surge coupled with an escalating conflict between Russia and UkrainePosted: February 28, 2022
Central Banks and Investment Markets
Since the GFC Central Banks have been targeting higher inflation and attempted to achieve this by artificially lowering interest rates through various monetary policy tools and in conjunction with government led fiscal measures. In a post COVID world their rhetoric shifted focus with a preparedness to let inflation rise above previously stated targets in order to kick start economies.
During most of 2021 many countries, including Australia, experienced a notable uptick in inflation. In the first half of 2021 the uptick in inflation was largely viewed as “transitory” by central banks and thought to be a short-term problem that would dissipate within a few months. This view changed in the second half of 2021 with inflation remaining persistent and increasing in some countries. As a result, some central banks have been forced to re-assess their view of inflation as being transitory and enact policy to combat persistently high inflation. This has resulted in investors adopting a more cautious stance as key dynamics that have underpinned very strong sharemarkets have changed.
There was a perception that very low official cash rates – set by central banks – would persist for a number of years fueling investors to pay more for assets such as shares and property in order to earn adequate rates of return believing that “There Is No Alternative (TINA)”. As a result, prices for many assets grew strongly.
As investors now anticipate higher official cash rates and witness persistently high inflation their assessment of risk and reward changes. All of a sudden “TINA” doesn’t exist for some investors with bond yields having increased to a satisfactory level for some investors to re-allocate capital. In addition, higher borrowing costs make it less attractive for investors to utilise borrowed funds and some investors may choose to repay debt rather than absorb higher borrowing costs.
All of these dynamics together with heightened geopolitical concerns have led investors to be more cautious during 2022 and investment markets are now showing a greater acknowledgement of downside risks which has started to be priced into stocks and bonds.
Inflation appears to be an “unintended consequence” of the COVID-19 recovery. The dramatic slowdown in many industries over the past two years has resulted in supply chain disruptions and dislocations that continue to put strains on the global economy today. The emergence of the highly transmissible Omicron variant of COVID-19 has complicated the recovery.
Many industries have suffered significant labour supply disruptions as the virus spread amongst the working population resulting in large numbers of workers having to isolate without adequate spare capacity to replace infected/isolated workers. As a result, the ability to provide adequate levels of service/supply of product in many industries has been impacted. Whilst the economic impact of this can be expected to be transient, it does exacerbate previous supply chain disruptions and extends the timeframe until inventories are replenished and supply chains are back to normal. Furthermore, it provides a “ripple effect” through the economy where intermediate goods are impacted. The supply chain disruption for one particular item becomes a problem if it is a component in another. For example, the global automobile industry has been unable to produce at capacity over the last couple of years due to a shortage of semiconductors. As such, demand/supply imbalances are occurring leading to lack of availability and/or price increases.
Rising input costs
The rapid shutdown of a number of people-facing industries during the past couple of years has meant many people have had to re-purpose and find new employment in new industries in order to survive. In addition, people who are close to retirement age have decided to bring forward their retirement in many instances. As such, there are labour shortages in parts of the economy that were most impacted by the downturn such as hospitality. In order to attract employees, noting the lack of overseas casual workers, it has become necessary to raise wages and increase incentives such as sign-on bonuses. This has been one of the key contributors to rising costs and businesses needing to raise prices.
Commodity price rises
Prices for items such crude oil, gasoline, natural gas, coffee and cotton have all increased by over 50% in the last 12 months. Price rises of this magnitude impact the whole economy. A major cost component for the transport industry is fuel costs and rising costs of this magnitude lead to higher prices for transportation. In turn, rising transport costs add to the delivered costs of many other goods in the economy. Businesses are then under pressure to raise prices in an effort to retain profit margins. This will then impact a whole range of other goods in the economy and put pressure on prices for those items.
Why is rising inflation important?
Overall, rising prices erode the spending power of consumers. As such, consumers become very aware of their diminished spending power and look at ways to improve their situation including asking for wage increases. If wage increases occur, then there are increased costs for other products/services within the economy and pressure to raise prices to maintain margins. This dynamic is a wage/price spiral and can lead to sustained higher levels of inflation. In recent years wage increases have been limited by low/negligible levels of inflation, adequate labour force and wage increases have been tied to productivity improvements.
What can central banks do to contain inflation?
Central banks are able to temper the rate of economic growth in an economy by raising the official cash rate. The cost of borrowing for businesses increases as interest rates rise and as borrowing costs increase this tempers the rate at which businesses can fund growth leading to a slow-down in economic activity. The slow-down in activity puts less strain on supply chains as consumers spend less as the attraction of saving compared to consuming has become more favourable. In addition to raising official cash rates central banks can (where applicable) curtail/halt quantitative-easing – a process whereby central banks purchase longer term securities on the open market in order to help maintain interest rates at low levels. Quantitative-easing encourages lower interest rates on the open market and creates an environment conducive for borrowers to borrow given the attractive cost of debt. Ceasing quantitative-easing and even reversing it, deploying quantitative-tightening are tools available to central banks in helping to manage inflation.
Russia’s invasion of Ukraine
The invasion of Ukraine by Russia has a number of implications. Firstly, the loss of human life within Ukraine as a consequence of conflict needs to be acknowledged. The loss of sovereignty by Ukraine violates the equilibrium in foreign relations that has existed for many years and adds new risks to international relations. Countries bordering Ukraine such as Poland, Romania, Slovakia, Moldova and Hungary will potentially have a new neighbour (Russia) if Russia gains control of Ukraine. This changes international relations in the region and heightens tensions with Poland, Romania, Slovakia and Hungary being all members of the North Atlantic Treaty Organization (NATO). Being members of NATO is important as NATO was formed originally to provide collective security against the Soviet Union and includes members such as the United States and Germany. As such, any encroachment by Russia on a NATO member’s borders has the potential to invoke a military response by NATO. Ukraine is not a member of NATO although it had been seeking membership to both the European Union (EU) and NATO prior to the Russian invasion.
Disruptions to global trade
Whilst it appears that Russia’s invasion of Ukraine will not see a direct military response from other countries it has provoked a number of western countries to invoke sanctions. These sanctions are aimed at key individuals and industries within Russia with the intent to restrict access to capital and debilitate the ability of certain industries to function thereby putting pressure on individuals and industries with the intent to weaken the Russian economy. As the impact of sanctions mounts it is hoped that this will encourage negotiations and ultimately lead to a suitable resolution for all parties. However, the impact of sanctions can take some time to take effect and can be diluted by other countries friendly to Russia seeking to provide aid and support where possible. Furthermore, sanctions are likely to invoke a response by Russia. This may see Russia taking action in an effort to apply economic pressures of its own.
Russia is a globally significant commodity producer
Russia is a globally significant producer in a number of key commodities and may decide to restrict exports of these commodities to retaliate against sanctions imposed by western countries. In particular, Russia is one of the three largest oil exporting nations globally. In addition, Russia supplies nearly 40% of Europe’s natural gas requirements and is an important source of energy for Europe. Russia does have leverage should it move to restrict energy exports. However, such a move would hurt Russia’s economy and may be countered by increased production from key oil producers such as Saudi Arabia and the US. Russia is one of the three largest producers of wheat globally and the largest exporter of wheat. Importantly, Ukraine is also amongst the ten largest wheat producers and exporters and any decision by Russia to restrict exports has the potential to cause a material imbalance in wheat supply which could see wheat prices move higher. Other commodities where Russia is a globally significant producer include nickel, aluminium, cobalt, platinum and palladium
Financial Market Implications of Russia invading Ukraine
The degree to which financial markets are impacted by the Russian invasion of Ukraine over the medium term remains unclear. It is clear that there has been a change in the geopolitical landscape but much will depend on the effectiveness of current sanctions on Russia, any counter measures deployed by Russia and the consequences of how any change to ongoing geopolitical risk is priced by investors. The loss of sovereignty by Ukraine could have wider implications around the globe including increased defense spending, new defense alliances being formed and more focus on simmering situations such as Taiwan’s bid to remain independent of China. There is potential for changes in supply and demand of key commodities and this may result in further imbalances leading to higher prices over the medium term and even a shift by some countries to become more self-reliant.
Investors are currently having to grapple with a number of changes to the investment environment and the impact these will have on their perception of risk and likely returns moving forward. Higher levels of inflation, increasing interest rates and a change in geo-political risk are significant changes to the investment landscape and heightened levels of volatility can be expected.
To this end, it is not uncommon for investors to have increased levels of concern or anxiety during such volatile periods in markets, however, it is important that investors do not lose sight of their longer-term objectives, remain focused on their investment strategy and avoid making short-term emotional investment decisions that are detrimental to achieving longer term objectives.
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