We have understandably had a lot of questions from our clients on the implications of Russia's invasion of Ukraine. We are acutely conscious that the situation has turned into a humanitarian crisis, with tragic scenes in the media on a daily basis.
We have no special insight as to how long the war will last or the outcome. However, we have a responsibility to all our clients who have entrusted us with their assets and we can comment on the implications for global growth, inflation, interest rates, sentiment and markets.
We provide our answers to the most commonly-asked questions below.
Which economies will be most impacted by the crisis, besides Russia and Ukraine?
Europe is highly exposed given that around 35% of its gas supply comes from Russia. For some individual countries, the figures are even higher: Italy imports 46% of its gas from Russia, Germany 49%, Finland 94% and countries including Macedonia, Moldova and Bosnia are 100% reliant on Russian gas supply.
With the suspension of the Nord Stream 2 pipeline and the potential for further supply restrictions, rising gas prices have the potential to impact the growth outlook for Europe as a whole. We have downgraded our growth expectations for the region as a result.
In contrast, the US remains relatively self-sufficient when it comes to energy and agriculture, with little economic exposure to Russia (who were only their 26th largest trade partner as at the end of 2019). The US economy is seemingly far better positioned to deal with economic implications of continued tensions.
This fact has been recognised by financial markets and reflected in recent performance. Since the start of the invasion on 23rd February, the S&P500 is up 3% in sterling terms to the 7 March. Over the same period, the Eurostoxx 50 index is down 11%.
Is remaining invested really the right strategy?
When share prices become volatile, it can be tempting to take money out of the market with a view to re-entering when things settle down. In our experience, it’s the wrong approach. Historical data suggests that trying to time the market in this way can be very costly, as Schroders’ Head of Research explores here. He also notes that 10% falls in markets – a similar magnitude to what we’ve seen so far this year – are very common and don’t undermine the long-term track record of equities.
Markets’ reaction to previous geopolitical shocks should provide further reassurance. As the table at the bottom of this article shows, markets have tended to recover quickly from wars and other geopolitical shocks – especially when the US economy is not in recession. While the probability of a recession has increased, our base case at this stage remains that we will not see a global recession over the next year.
There’s another point to bear in mind. For most of our clients, we manage multi-asset portfolios. While equities are under pressure – and could remain so for a while yet – the defensive and diversifying assets we hold have been performing better. Defensive assets include gold and government bonds, both of which have posted positive returns since the invasion. Diversifiers include exposure to a basket of commodities, which have performed strongly in recent weeks.
How have safe haven assets performed?
Developed market government bonds have struggled for much of the year, with bond yields rising - and prices falling - in anticipation of central banks raising interest rates. Since the invasion, this trend has reversed slightly, as investors have become increasingly concerned about the economic outlook.
Government bonds remain a good hedge against growth shocks and geopolitical risk. However, with inflation still elevated, the factors driving January’s underperformance remain in play. We are likely to see a "tug of war" between risks arising from the Ukraine crisis on the one hand and the need for central banks to raise interest rates to address rising inflation on the other.
Given the potential for a more challenging environment for bonds, we continue to prefer alternative defensive assets such as gold. Gold has historically performed well during both inflation and growth shocks and offers a hedge against the potential for a more stagflationary environment (one of slowing growth and rising inflation) as a result of the crisis.
Are we heading for a repeat of the 1970s?
Western economies experienced very high inflation in the 1970s and early 1980s, with prices in the US rising at annual rates of more than 12%. Oil was a key contributing factor. Prices spiked higher following the Arab-Israeli war of 1973 and subsequent conflicts in the region.
Prior to Russia’s invasion of Ukraine, inflation was already high – and well above central bankers’ targets. In the US, the annual rate of inflation reached 7.5% in January, the highest level since 1982.
The worry is that another spike in oil prices will cause inflation to become even more entrenched and trigger a cycle of rising prices, as we saw in the 1970s.
Even if oil and gas prices do rise further in the short term (as they may well), we think a repeat of the 1970s inflation dynamics remains unlikely.
For one thing, the world economy is much more globally integrated than it was. This means more international competition for many goods, limiting producers’ ability to raise prices. At the same time, significantly lower levels of unionisation means that employees are not in as strong a position to demand wage increases as they once were.
Rapid advances in technology are having a similar effect, with many jobs that could only be done manually in the 1970s now fully automated. This is also helping to increase companies’ productivity, reducing some of the pressure to raise prices.
Is the threat of stagflation rising and how should we hedge against it?
The threat of a stagflationary environment (one of slowing growth and rising inflation) has increased as a result of the Ukraine crisis. Consensus forecasts for economic growth have been falling across the US, UK and Europe, while inflation forecasts have been rising.
12 week changes to consensus growth and inflation forecasts
We are conscious of the challenge that this poses to investors across all asset classes. Companies may face headwinds from rising input costs and falling consumer demand which may squeeze margins. Within equities, an allocation to higher quality companies with the ability to pass rising input costs on to consumers should perform well on a relative basis.
Within fixed income, inflation-linked government bonds offer a degree of inflation protection, although we are mindful of the headwinds posed by rising interest rates. Historically, gold and broader commodities have performed best in periods of stagflation and we continue to hold exposure to both across our core strategies.
Average real (inflation-adjusted) YoY total return since 1977, %
What are the prospects for UK interest rates in the wake of the Russia Ukraine crisis?
Given the inflation backdrop, the expectation remains that the Bank of England will continue to raise intrest rates this year. However, with growing concerns over economic growth, as well as tighter financial conditions, we could see policy makers take a marginally more cautious approach with a slower pace of rate increases than is currently being anticipated by the market.
Number of interest rate hikes being priced in by the market
What does the current crisis mean for energy security and will we see an acceleration of energy transition?
Europe's dependence on Russian natural gas has once again brought energy security into focus. Given years of underinvestment in energy production, low inventories and continued strong demand, it will take time for market dynamics to improve.
The situation adds to the argument for transitioning the current energy system to one based on cheaper, clean and more reliable power. Energy transition will likely play a key role in the broader topic of energy security.
It is important to note that this will be a long term trend. In the near term, renewable energy companies will face challenges of rising input costs as a result of higher industrial metal prices and face issues with supply chain constraints which may hinder progress. We continue to believe that energy transition will however be a powerful investment theme over the next decade.
Geopolitical crises: a look back in history
As the data below suggests, markets have tended to recover quickly from wars and other geopolitical shocks – especially when the US economy is not in recession. We do not envisage a recession in the US over the next year.
S&P500 performance around select geopolitical / military events
Geopolitical / military events
1 month later
3 months later
6 months later
12 months later
Suez Canal crisis
Cuban missile crisis
Arab oil embargo
Iranian hostage crisis
USSR in Afghanistan
Iraq invades Kuwait
World Trade Centre bombing
Source: Truist IAG, Factset. Bold rows represent down markets where the economy was in recession at some point during the measurement period.
Issued in the Channel Islands by Cazenove Capital which is part of the Schroders Group and is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.