Markets were dominated last week by the growing expectation that a Russian invasion of the Ukraine was imminent. Global equities ended the week down 1.5%, back around their late January lows and off 7% from their early January high. Meanwhile, safe-haven assets rallied a little.
10-year US Treasury yields, which broke above the symbolic 2.0% level earlier in the week on fears of aggressive Fed tightening, subsequently retreated back towards 1.9%. And gold, the classic beneficiary of a geo-political crisis, also rose to close to $1900/oz, having spent the last few months moribund around $1800/oz.
The news over the weekend that another round of negotiations is on the cards provided the grounds for a rally in equities this morning. However, it proved short-lived, no doubt because a Russian invasion still seems to be the most likely outcome, with no palatable way for the Ukraine and the West to meet Russian security demands.
The Ukraine crisis has reinforced the inflation fears behind the recent dramatic reappraisal of the outlook for monetary tightening. The size of the impact of a Russian invasion, however, is far from clear. It will very much depend on the Russian response to Western sanctions and the extent to which it disrupts supplies of oil and gas, although Russia and the Ukraine are also major grain exporters.
Oil prices would very likely jump higher with the Brent oil price, which is currently $94/bbl, breaking above $100. As regards disruption to supplies, Europe (particularly Germany) is the most exposed with around a third of its oil and gas supplies coming from Russia. Still, increased liquefied natural gas shipments from elsewhere, along with a rundown of gas held in storage including possibly seldom used ‘cushion’ gas, should go a long way to alleviating the physical shortfall.
Usually, central banks try to look through any spike in energy prices, viewing it both as transitory and something they are powerless to affect. This time may be somewhat different. Further upward pressure on already inflated energy prices will drive inflation even higher near term, increasing the risk of a wage-price spiral. Such considerations mean an invasion is very unlikely to dissuade central banks from their monetary tightening plans, even if equity markets fell back significantly further.
The latest batch of economic data will also do nothing to dissuade the Fed and MPC from tightening policy. In the US, retail sales bounced back much more strongly than expected in January following a sizeable decline in December, and to a lesser extent the same was true in the UK.
Furthermore, today’s purchasing manager index numbers for the UK and Eurozone were unexpectedly strong. Companies appear to be doing their best to put Omicron behind them with UK business confidence rising in February to an 8-month high.
More importantly for the MPC, UK inflation once again surprised on the upside in January. The headline rate edged up to 5.5% from 5.4% while the core rate increased to 4.4% from 4.2%. Wage growth in December also exceeded expectations and is running around 4%. The latter may be well below inflation at the moment but is significantly above the level compatible with the MPC’s 2% inflation target.
Monetary tightening in the West will undoubtedly remain a drag on equity and fixed income markets over the coming year, just as the Ukraine could well be near term. However, we continue to believe corporate earnings will be the saving grace for equities, allowing them in time to resume their upward trend.
Rupert Thompson
Chief Investment Officer