Equity markets have continued to stabilize of late, regaining the lost ground that occurred a few weeks ago just before and during the early phase of Russia’s military intervention in Ukraine.
At the most acute point, the S&P 500 had retreated 12.5 percent year to date by March 8, and markets outside of the U.S. had fallen 13.1 percent, as measured by the MSCI ACWI ex US Index. As of the close of trading on Wednesday, these two indexes were down “only” 3.4 percent and 5.1 percent year to date, respectively. Canada’s S&P/TSX is up 4.0 percent year to date.
Barring escalation that would involve NATO countries, markets seem to have largely absorbed the military phase of the Russia-Ukraine crisis, as the S&P 500’s behavior has been similar to previous military conflicts and other geopolitical events.
The S&P 500 has rebounded off its lows (YTD % change)
The market retreated 5.6% surrounding Russia’s initial military intervention in Ukraine, near the 6.2% average decline of 18 previous military and geopolitical events since WWII
Line chart showing that the S&P 500 fell notably in January due to concerns about inflation and Fed rate hikes. On February 11, it began to start factoring in Russia-Ukraine risk. It fell 5.6% between that date and its low point on March 8. In total, the market declined 13.1% by March 8 on a year-to-date basis. The market subsequently rebounded and surpassed its February 11 level by March 18, recouping the losses from the military intervention. It then rose further and is down only 3.4% on a year-to-date basis through March 30.
Source - RBC Wealth Management, Bloomberg; daily data through 3/30/22
Mix encouragement with tempered expectations
Market participants are still reacting positively to headlines that signal progress in the Russia-Ukraine negotiations. The prevailing sentiment seems to be that if a deal is reached and military hostilities cease, it could spell further relief for equity markets and commodity prices. We think this sentiment is misplaced for two main reasons.
First, Russia and Ukraine are still very far apart on a number of fundamental issues, despite Ukraine indicating it will not seek NATO membership. The status of Crimea/Sevastopol and Donbass are two major sticking points (but not the only ones). Ukraine seems in no mood to cede what it considers to be its territory, and we don’t think its main allies would support this either. In turn, Russia cannot and will not negotiate on Crimea/Sevastopol as evidenced by a strict provision in its constitution (and wouldn’t regardless), and Russia will not backtrack on its recent recognition of the Donbass republics as independent. Meanwhile, the heads of the two Donbass regions just stated they intend to hold referendums to become part of Russia (like Crimea/Sevastopol did in 2014), after military hostilities end in their regions.
Second, even if Russia and Ukraine eventually agree to end military hostilities, we think most, if not all, of the anti-Russia sanctions that are impacting commodity prices would remain in place. UK Prime Minister Boris Johnson’s spokesperson told reporters, “The prime minister said a ceasefire alone would not be cause for UK sanctions to be removed on Russia,” according to Reuters. The prime minister of the Netherlands went further. During a state visit to Spain, he said a peace agreement with the loss of Ukraine’s territory and sovereignty will not lead to the automatic termination of EU sanctions against Russia, Reuters reported. We think their sentiments are shared by other Western leaders. In the U.S., there is no broad-based political support for lifting anti-Russia sanctions, as they are enthusiastically backed by Democrats and Republicans in Congress, many of whom were advocating punitive sanctions before Russian missiles began to strike Ukraine.
Commodity and equity markets will likely have to contend with a longer period of uncertainty about inflationary and supply chain shocks associated with anti-Russia sanctions.
In addition, keep in mind that Russia has barely begun to roll out its counter-sanctions. “No rubles, no gas” was its first major announcement in this regard. If EU countries refuse to pay for Russian natural gas supplies in rubles (or gold) rather than in euros or dollars, Russia could halt gas supplies sooner rather than later. This policy is primarily in response to EU countries freezing billions of Russia’s euro and dollar exchange reserves. Thus far, EU countries have refused to pay for gas in rubles. Russia is considering other “rubles for commodities” mechanisms on crude oil, industrial and precious metals, agriculture, fertilizers, and timber against countries that have implemented anti-Russia sanctions. Moscow is also studying whether to impose restrictions on uranium supplies to the U.S., which are used for nuclear power plants. These are just a few potential counter-sanction examples.
Furthermore, we don’t rule out that a new sanctions front could develop, albeit much less in magnitude. Western sanctions could be imposed on countries that are choosing to remain “neutral” in the Russia-Ukraine conflict and not implementing anti-Russia sanctions of their own. The U.S. State Department has already hinted as much. China and India seem like the biggest targets. If such actions take place, China’s Foreign Ministry indicated there would be a tit-for-tat response.
We think energy, metal, and agriculture commodities will continue to be priced with a “sanctions premium” (also called a “geopolitical risk premium”)—higher than they would have been had the Ukraine crisis not occurred—and this will exert pressure on global inflation, supply chains, and economic growth for at least the time being.
When will such pressure lift? It will take time for Europe to shift away from Russian commodities. Likewise, it will take time for Russia to re-route its commodities further toward Asia, including to China and India, and to other countries that have not imposed sanctions (currently 140 of the 190+ countries in the United Nations, by China’s count). We have not yet seen credible estimates as to how long these processes could take.
What makes the U.S. and Canada more resilient?
Given the lingering inflation, supply chain, and growth risks, there is a wider range of potential outcomes for the global economy and corporate earnings in 2022 than there was just a few months ago.
The silver lining is that the U.S. and Canadian economies are better equipped to handle these risks than European economies. The U.S. and Canada, especially in combination, are much more self-sufficient due to natural resource abundance, and they have fewer direct and indirect ties to the Russian economy. While Russia is the world’s largest commodity producer, the U.S. and Canada are either at the top or near the top of the ranks in a wide variety of energy, industrial and precious metal, and agriculture commodities.
The U.S. and Canada both have the benefit of primarily selling their commodities and other goods and services to the largest market in the world—the U.S. Even the S&P 500, which includes many of the largest and highest-earning multinational companies in the world, derives roughly 70 percent of its revenue domestically; less than 12 percent typically comes from Europe.
For these reasons, and importantly because U.S. recession risks are currently rather low according to our leading economic indicators, we remain moderately Overweight U.S. equities and have a constructive Market Weight stance on Canadian equities. For long-term investors who have money to put to work and have a dollar-cost averaging plan—and would rather not be sitting on a lot of cash in an inflationary environment—we would stick with the plan.
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