Market Update – Implications of the Russia-Ukraine Conflict

FMPWA_1255_centered

Thursday, February 24, 2022

David Pfeiffer, Associate Portfolio Manager & Investment Analyst

The conflict in Ukraine has escalated quickly with Russia launching a full-scale invasion last night. Global equity markets are pushing lower today with Europe under the most pressure and the U.S. dropping further into correction territory as market participants grapple with the uncertainty of how the conflict will impact global growth and commodity prices. At the time of this writing, the S&P 500 has stabilized a bit, down 1% after opening over 2% lower, while major European stock indices are down between 3% and 4%.

Amid this volatility and the relentless headlines, our team at First Merchants Private Wealth Advisors is focused on assessing risk from a fundamental, long-term perspective. We continue to monitor and discuss how this conflict will impact economic and corporate profit growth and the trajectory of inflation both globally and domestically and if and how asset allocations should be adjusted as a result. Below is our current perspective but we will remain nimble as the situation evolves.

What we know now about the economic impacts of the conflict

One of the key fundamental impacts of the conflict in Ukraine is the disruption to commodity markets. Energy has gotten the most attention as Russia is Europe’s largest supplier of natural gas, supplying roughly 40% of the continent’s natural gas supply, and it produces roughly 10 million barrels a day of crude oil, which is equivalent to about 10% of global demand. Brent crude oil prices have pushed past $100 per barrel today, after rising 27% already in 2022, and natural gas futures are up 5% today. Putin has promised not to disrupt the natural gas supply to Europe and it remains strongly in Russia’s economic interests to continue selling its energy, but that could be a target for future sanctions or counter-measures.

Other important commodities will also likely feel the pinch from the conflict. Russia is a leading producer of wheat and fertilizer that will likely fuel higher food prices as well as palladium that is used in semiconductors. Meanwhile, Ukraine is a major producer of neon gas critical for chip manufacturing, providing over 90% of U.S. semiconductor-grade neon.

The conflict in Ukraine is likely to compound some of the issues and disruptions that the global economy was dealing with in the wake of the pandemic with further short-term inflationary pressures and setbacks in areas like chip manufacturing. However, the extent to which it sustainably weighs on global growth depends on a lot of unknowns including the duration of the conflict. Europe is likely to face the greatest headwinds with their proximity and dependence on Russian commodities, but there will be knock-on pressure to global markets.

What comes next?

Western nations have vowed to sharply escalate sanctions on Russia in response to heightened attacks from Russia. We are awaiting further news on sanctions from the U.S. and its allies. Among the key questions for markets is how central banks respond and adapt their policy plans. The rising inflationary pressures from the conflict and the potential to weigh on global growth complicate the path forward for the Fed and other central banks. We expect the current spike in commodities will act as a “tax” for US consumers and will likely result in a slower path of policy normalization by the Fed. All else equal, we should expect less aggressive rate hikes than were priced into the markets only a few days ago.

How should investors respond?

While much remains uncertain about magnitude and duration of the conflict and the resulting effects on markets and we do anticipate further short-term volatility as the situation evolves, geopolitical conflicts have not historically derailed equity markets over a medium-term horizon. Well-diversified portfolios have historically weathered geopolitical tensions quite well and the greatest risk to investors in these times of turmoil comes from shortening their investment horizon and reacting by selling at poor prices.

Our investment team has positioned our clients’ portfolios with an overweighting to U.S. equities over international markets. U.S. markets, while not immune, face lower direct risk than Europe and the U.S. dollar is seen as a safe haven currency that outperforms in risk-off periods. Our investment portfolios also emphasize a focus on companies with durable and defensive profitability and rock-solid balance sheets to weather economic storms. Finally, our fixed income portfolios emphasize high-quality investment grade bonds that will help act as a ballast to equity markets in the event of economic slowdown. We will be watching credit markets closely for signs of stress that would warrant a reduction in risk assets.

We stand ready to guide our clients through these uncertain times and we will be vigilant and work to provide you the best possible advice to assist you in meeting your long-term investment goals.