Martin Lefebvre (ML) & Jake Jolly (JJ)
(ML)
Thank you for tuning into this NBI Podcast. Last week we talked about the war in Ukraine, its implication on commodity prices and inflation, and the broader impact of supply chain issues. This time around, we’re going to talk about market implications from an investor’s point of view, and to do that, my guest today is Jake Jolly, Senior Strategist at BNY Mellon. Jake, welcome and thank you for being with us.
(JJ)
Thanks for having me.
(ML)
Jake, why don’t we start by assessing the state of the markets? Can you tell us how global markets have reacted so far after a month of war? And in your mind, are there any market moves worth highlighting?
(JJ)
Yeah, certainly. I think the initial market reaction was a clear flight to safety. You know, we saw equities decline. Bonds rallied gold, the U.S. dollar rose just to give you a few numbers: that first week and a half after the invasion on February 24th, the German DAX (Blue Chip), German companies declined more than 10%, the stock 600 or broad measure of European equities, declined over the same period about 8%. And of course, this was not just a year up story because on a global scale, the MSCI All Country World Index, the broadest measure of global equities, was down about 4%.
At the same time, we saw sovereign yields, they came in briefly, but then kind of quickly continued their upward trend, which we had characterized much of the year. And lastly and probably most importantly, we saw that commodity prices reacted very strongly. It makes sense given Russia’s significant role in global energy and commodity markets. Brent crude oil price increased by about 40% in this for the first week and a half through March 8th. The Bloomberg Commodity Index was up about 15%. Now where does that leave us today? We are about one month out from the start of the war. Losses in equity markets have largely been recouped, so the MSCI ACWI is up about 4% on its February 23rd level. The stock 600 is flat. The German DAX is down, but only by about 2%. The continued fluctuations in oil prices has been sort of the major driver over this period, which makes sense just given the particular sensitivity to a risk of prolonged elevated energy costs that they could certainly dampen the global growth outlook.
That extreme volatility is illustrative of just how uncertain this situation is. You know, sanctions have been evolving very rapidly and the market is struggling to work out sort of expectations around supply, not just the near term but the medium term. And just to briefly summarize how volatile the oil price swing has been, you know, we came into this year with tight global spare capacity and crude oil was at about $70.00 per barrel at the end of November last year. It had increased to $90.00 per barrel in early February. Upon the invasion, oil jump to 105, sanctions were being announced. Companies were starting to sell sanctions and avoid Russian crude, and we saw oil push even higher. And on March 8th we were above $130 per barrel. So a very significant jump over a pretty short amount of time. But it’s really swung since then. You know OPEC officials came out saying that they were favorable to attempting to boost capacity or boost supply. A faster oil quickly came down back to $100 per barrel, but has since again retraced went back to 120, has since come back. I was checking this morning; we are around 110. It’s really been a rollercoaster, but certainly even at sort of the 110, or pretty significantly up for the year, and what I’m seeing is that we are seeing a growing willingness on both sides to use energy supplies as a tactic, as a weapon within this conflict and sort of the latest headline there is that Russia is planning to demand payments for its natural gas to be made in Russian ruble. We will see what comes with that. But I think at the end of the day it’s a very fluid situation and it’s not likely that oil markets are going to settle down anytime soon and that’s going to have a knock on effects for global equities.
(ML)
I understand. Speaking of equities, you mentioned that equities had recouped almost half of the losses that we’re noticing since the beginning of the war. Could beforehand markets and draw any parallels with what happened in 2014 with the annexation of Crimea or it’s a totally different conflict?
(JJ)
Yeah, it’s a great question and it’s one of the first things I did on February 24th when I logged onto Bloomberg, I looked and unfortunately even on that first day, it seemed that this conflict was going to be much more severe than to the Crimea annexation. So as a quick refresher, that invasion took place in February of 2014, but it was much smaller on a military scale. It was only about a month in terms of its military operations and very few casualties. It really doesn’t even begin to compare with what we’ve seen in Ukraine over the past month. And I think maybe most importantly that sanctions that came out of that period were far less severe and far-reaching. Markets never really seemed to be concerned that Russian oil was going to be removed from global markets, so we didn’t see anything like the market volatility that we’ve seen in the past month.
I think today’s conflict is orders of magnitude different and certainly in our view could be a major reset of geopolitical relationships, not just with Russia, but China as well. And unfortunately, I think that we’re still in the very early days in terms of the true extent and impact of sanctions on financial markets as well as with the conflicts. We all hope that a negotiated ceasefire is sooner rather than later. But I think that, unfortunately, we’re still in potentially early days and that it could hang markets for some time.
(ML)
Yeah, I think you’re right. This conflict seems to be going nowhere with the Ukrainian army offering much more resistance than Russia was hoping for. What would be the implication for markets of a drawn-out conflict?
(JJ)
It’s certainly a risk that the longer the conflict drags on (months, years, hopefully not), but it would certainly increase the risk of severe consequences for global economies. Energy prices could remain elevated for much longer and that has significant consequences for global aggregate demand. Our team, we focus on analyzing probabilistic scenarios. One of our main scenario passes right now is this protracted conflict; it does deserve a meaningful probability. Now Russia is small from a global GDP perspective, but it is critical from an energy and commodity supply perspective. The OECD has some estimates: if commodity and financial shocks that we saw in those first two weeks, if those were to persist over the next year, global growth could be reduced by 1% and inflation could increase by more than two and a half percent. And unfortunately, we think that’s probably optimistic. We think that if mediation fails to defuse the fighting, global energy supplies are going to remain at risk. And that certainly raises the risk of severe consequences, particularly for those European economies given their reliance on Russian energy imports.
(ML)
What type of probability do you put on such a scenario? Do you have a number?
(JJ)
I do have a number, we have about 35%. And I will certainly point you to our publication, which lays out: it’s a nice probability tree. We are economists and financial analysts. We are essentially not taking a view on whether the conflict will be short and contained or long. We start our first step of our probabilities for this review is this basically a 50/50 probability either way. And this protracted conflicts, we certainly think it has risks to, not just energy markets, but more broadly to commodity markets because we could see it impact global production, metals and we’ve already seen some disruption within commodity markets. Nickel being kind of the one that everyone’s been reading about. Again, it’s a meaningful probability. Certainly, it’s not the one that we hope to see, we could see inflation push higher from here. It could stay higher for longer and ultimately that could hit real incomes and particularly in those energy importing economies that’s going to result in a slowdown in world GDP.
(ML)
Jake, you mentioned that everybody knows that Russia is in a very dire situation right now with all those sanctions. What would be the implications for global investors in your mind?
(JJ)
Just a quick recap. On March 2nd, MSCI reclassified Russia from its emerging market status to a stand-alone status, stripping it of being an emerging market for index purposes and this was following consultation with asset managers and recommendations that the Russian market had become uninvestable. First off, this is kind of a good reminder that index construction is a much more active process than many people give it credit. Often indexes are thought of as being these passive broad market exposures, but index providers do have discretion over what is in the index, and this is a good reminder of how that could change quickly. Fortunately, the Russian equity market is relatively small. It was obviously much smaller post-invasion as the market essentially collapsed and trading was frozen. We’re only seeing now that equity markets start to open again with new restrictions on trading. If we go back in time, the weights of Russia within the emerging market indexes have been declining for some time. So back in 2007 it represented about 10% of the MSCI Emerging Market Index. But coming into this year it was only about 4%. That’s an even smaller percent when you look at global benchmarks. On a global basis, it’s something less than 50 basis points, so relatively small. And from that perspective, removal is going to modestly increase the weights of the remaining constituents, but it wouldn’t be expected to be overly disruptive from an index tracking and performance perspective. For investors that do or did hold Russian securities, certainly there are going to be difficulties in closing out those positions. They might be already marking those securities at zero and if they are eventually able to divest it, it may come at a significant discount. So certainly, a difficult period for those managers with a significant Russian exposure.
(ML)
The heavyweight of that emerging market index is clearly China and with the development of different economic poles, will China benefit from all of this noise surrounding the conflict?
(JJ)
Yeah. It’s a great question and I certainly don’t think I will do it justice here in covering it in a couple minutes. I will try to summarize what I think are some of the key developments. Very early on, after the invasion, Chinese stocks sank as sanctions were rolled out. And I think the speculation that U.S. sanctions were going to adversely impact China, given China’s alignment with Russia. Now Chinese authorities came out quickly and tried to separate themselves from the crisis. And they were emphasizing that they do not want to be adversely impacted by sanctions. Of course, I don’t think Chinese companies are going to go out of their way, and you know tell everyone that they’re complying with sanctions. But at the end of the day, I think that they will be complying with global sanctions and we’re already seeing that Chinese buyer that had initially shunned, it’s now being reported that China independent refiners are starting to buy Russian energy products through private negotiated deals, but again, continuing very cautiously, there’s no evidence that Chinese companies are attempting to avoid sanctions. And while Russia depends heavily on China as an extra external trading partner, China is simply much more connected to the U.S. and Europe as being key markets for its products. My view here is that China is probably going to try to walk a fine line of continuing to diplomatically support Putin and Russia, but from sort of the business and financial ties, you know they’re just far too important to risk by overstepping or pushing back on sanctions.
That comes particularly considering the domestic situation in China. We’ve sort of been describing this triple headwind of the zero COVID policy, which is going to be difficult, is already showing how difficult that is to manage and then combine that with the ongoing slump within the property market and then weaken confidence stemming from the crack down on the tech sector last year. So those are all headwinds, the growth target for this year in China is probably overly ambitious. I think China is going to make the decisions that are best for them.
(ML)
That’s something that we’ll have to keep monitoring very closely soon. Another thing that I guess we’ll need to monitor – we always look at the war or conflicts in isolation but depending on where we are in the economic cycle, it could have different impacts. And nowadays with inflation picking up, it’s certainly had an impact on monetary policy expectation. Does the war change how global central banks are handling monetary policy?
(JJ)
Well, I don’t think their jobs are getting any easier. Historically, central banks have taken this view that they should look through exogenous price shocks such as the one that we’re seeing within energy markets. The general idea here is that they try to leave policy largely unchanged and delay any major policy decisions until uncertainty resolves or at least there’s a bit more clarity on how external shocks going to play out. That is generally because they try to focus on medium-term expectations. They’re not looking to manage month to month volatility and certainly their mandate globally tends to be focusing on that medium-term inflation expectations. Of course, we’re not in a normal environment, as you’ve already alluded to. We are facing inflation that is meaningfully above target in many countries and some of them have extremely tight labour markets and there’s already considerable nervousness around this shift upward and inflation expectations. And ultimately that’s leaving very little room for central bankers to maneuver through this current crisis. That means there’s certainly a risk that central bankers take a different tactic this time around, so if we see a situation where energy prices remain high or even spike higher from here, and that ends up being a concern for those medium-term inflation expectations, we could find ourselves in a very challenging situation where central banks are tightening into a slowing economy. That’s certainly a situation that central bankers won’t want to try and avoid and would be unambiguously bearish for both economic growth and risk assets. We’re particularly concerned about that within Europe, keeping a very close eye on it, but, of course, so much of it is dependent on the outcome of the war. It’s very difficult to say where we’re going to be in a few months.
The last point that I’ll make is a broader theme within central banking. Central banks generally professed to be very data dependent and try to be flexible in their approach to tackling high inflation. But inflation forecasts have been very poor and quite unreliable over the past year. Trying to be data dependent while your forecast has been very poor means that forward guidance has been shifting quite a bit and that certainly was impacting markets in January as globally central banks turn much more hawkish than they had been even a month prior, and unfortunately markets just don’t like that. I think this latest crisis isn’t making things easier, but hopefully if we do negotiate a ceasefire if commodities come down and are on a more stable footing, that will certainly make the policy path more certain and more stable going from here.
(ML)
Time is flying by, but I musk ask you the $1,000,000 question, how should investors be invested in all of this? Is it already priced in your mind or there are still risks ahead of us?
(JJ)
There are risks ahead and what I’ve been advising clients is anytime you’re in a situation where you’re facing greater uncertainty, it’s the time to not take large directional bets, particularly when what is potentially driving large movements in either direction within the market is going to be the outcome of the war. And I think that is particularly true within European markets. When we started this conversation, I laid out the fact that European markets pull back strongly, German markets down more than 10%. If it has essentially come back to where it was before the crisis, I think we’re all happy to see that. But we’d be much happier and more confident with those levels if there was real progress towards a negotiated ceasefire. Until you see meaningful progress there, it’s going to be difficult to look at the market with a lot of conviction that there’s an upside from here and for that reason, that’s why I would advise you know, it’s about how I make my portfolio more robust in the face of this volatility. One way to do that is to consider increasing your holdings and your exposure to those companies that provide exposure to the quality factor. The quality factor has a lot of definitions, but broadly speaking, it is those companies that have strong profitability characteristics. Strong balance sheets and over long stretches of time they have outperformed the lower quality names and they’ve done particularly well in down markets. It’s certainly an area that makes a lot of sense anytime you’re going through a volatile period like this.
It makes sense to go back to investing first principles anytime there’s a lot of market nervousness and certainly even before the Russia-Ukraine crisis, there was a lot of nervousness in the market because we’re going through a rapid regime change from you know post COVID boom to a tightening monetary policy cycle globally. Knee-jerk responses are historically not going to benefit you in the long term. You know, being very myopic and not seeing beyond the next couple months is unlikely to play out well for you. Secondly, just a reminder that diversification is your friend and that’s not just you know across sectors within your domestic market but it’s across geographies globally, it’s across asset classes and fixed income has certainly been beat up quite a lot in recent days, recent times and there are certainly headwinds to fixed income from here with the right environment likely to continue higher. But you don’t want to forget that historically fixed income has been an important diversifier to equities. Given how much volatility we’re seeing within equities, it’s certainly not a good idea to completely give up on your fixed income exposure.
(ML)
I would tend to agree with you on that one. There’s certainly a lot of things that can happen over the next couple of months. That’s the that all the time that we had today. Thank you so much for being with us. Just as a reminder, Jake Jolly is a senior investment strategist with BNY Mellon Investment Management. Thank you everyone for being with us and we will talk again soon. Thank you again.
Martin Lefebvre
