Central bank hawkishness drove up bond yields before investors switched into safe-haven assets such as government bonds and covered underweight positions after the onset of the Ukraine war.
Major central banks reaffirmed their intent to exit ultra-accommodative monetary policies. The ECB voiced its increased concern about inflationary pressures in the eurozone, while the US Federal Reserve toughened its stance compared to January.
However, the shock to the global economy from Russia’s invasion led markets to anticipate the risk of stagflation. Soaring energy and food prices look set to exacerbate existing inflationary pressures, while higher-for-longer inflation cuts into real disposable income. The magnitude of the negative consequences for growth will depend on the duration and extent of the conflict.
To date, it appears that the Fed will pursue plans to raise rates at its next policy meeting, most likely by 25bp. However, market participants expect the ECB to adopt a ‘wait-and-see’ approach until the consequences of the current crisis become clearer. In the medium term, however, we believe normalisation of its monetary policy remains on the table.
Bond yields reflect shifting mood
The yield on the US 10-year T-note (1.78% at the end of January) rose to above 2% on 10 February after consumer price data for January showed a 7.5% YoY rise, its highest since February 1982. The 2-year yield (1.18% at end-January) climbed to 1.60%, its highest since the end of 2019, as it became clear that labour market strength could lead to a significant acceleration in wage rises.
After comments by Jerome Powell and other FOMC members who are even more committed to raising policy rates quickly (such as James Bullard, St. Louis Fed President, in favour of a 1% rate increase by July), market expectations solidified.
The 10-year yield hovered at around 2% until 23 February before safe haven buying and covering underweights drove it lower.
24 February: A turning point, also on the markets
As usual when international tensions rise, markets saw a flight to safety. Commodity prices (oil, natural gas, agricultural products) rose. Brent crude rocketed up by 10.7% in February to end above USD 100 a barrel, the highest since September 2014. The price of European natural gas soared by 16.4% and – with Russia and Ukraine accounting for almost one quarter of world wheat exports – wheat prices shot up by 21.9% to their highest point since 2012.
Given the seriousness of the shock and allusions to the use of nuclear weapons, the rise in gold prices was relatively modest (+6.2%).
How the various equity indices performed reflected either the country's direct involvement in the conflict or its geographical proximity.
The Moscow MOEX index lost 30% and the rouble fell by 26.3% from the end of January. While Russia's weight in international indices is relatively small, it accounts for two-thirds of the MSCI Emerging Markets Europe. This fell by more than 40%. Latin American equities benefited from the rise in commodity prices, while markets in Asia, a net importer of oil, posted a slight decline.
Eurozone indices underperformed other major developed markets with a 6.0% fall in the EURO STOXX 50. Implied volatility returned to its highest since the end of October 2020. The decline in US equities was less severe (-3.1% for the S&P 500) as was that of Japanese equities (-1.8% for the Nikkei 225).
At the global level, only the energy and materials sectors gained in February. Defensive sectors (telecommunications, consumer staples and healthcare) posted modest declines and outperformed the broader market. In the eurozone, financials and cyclicals (consumer discretionary, technology) saw the biggest falls.
Lower growth, stronger inflation
The Ukraine crisis has significantly increased financial market volatility and uncertainty about the economic environment – just as the world was emerging from the pandemic. However, to date, the economic situation has not fundamentally changed: Global demand remains strong and the supply constraints that arose due to the pandemic are starting to ease.
Economically, the eurozone’s direct exposure (in terms of exports) to Russia and Ukraine is limited. It is unevenly distributed across member states, as is their dependence on energy imports. Any stalemate in the conflict would, however, weigh on household and business confidence and could limit growth. Nevertheless, global GDP growth is likely to remain well above the average seen before the first major pandemic lockdown, so the short-term outlook does not seem to have changed dramatically.
One factor needs tracking: the rise in energy and agricultural commodity prices. This will further push up producer and consumer prices. Central bank inflation forecasts for 2022, which were already high, will likely be revised upwards in the coming weeks.
Bonds look overvalued; equities reduced
Against this background, even though the Fed and the ECB indicated that they would take the Ukraine situation into account, investors may have been too quick in concluding that the central banks would abandon their plans to normalise monetary policies. Bond markets may now look overvalued relative to the (strong) fundamentals.
We have increased liquidity by reducing our exposure to eurozone and emerging market equities to protect portfolios. We believe our slight overexposure to Japanese equities and cyclical commodities remains appropriate given the current lack of clarity and the likelihood that volatility will persist for some time yet.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions)
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.