The Ukraine crisis has moved to the centre of investors’ radars. Several geopolitical analysts now assign an elevated risk of an incursion into Ukraine by Russian forces. However, they assign a low probability to a protracted conflict, given the US threat of overwhelming sanctions against Russia. Historically, such geopolitical events have impacted financial assets only for a short period. Given this, the best course for investors, the view would be to stay invested in a diversified allocation, but hedge against any short-term military action through exposure to safe havens, such as gold and an undervalued JPY.
The Ukraine crisis comes against the backdrop of a 30% surge in oil prices in the past two months, soaring inflation and expectation of tighter monetary policy. This context is important because the Ukraine crisis’ main channel to global markets is through natural gas prices in Europe and oil prices in general. There is concern that Russia might cut off natural gas supplies to Europe, albeit temporarily, in retaliation for any US sanctions. Thus, European equities are likely the most vulnerable to temporary volatility in the event of an escalation. Nevertheless, in the past, limited-duration military conflicts have resulted in a 10%-15% drawdown in US stocks. Since US stocks are already down about 9% from their January record high, the scope for further drawdown is relatively limited, in our assessment.
For the medium term, it is important to assess whether any escalation in Ukraine will fundamentally alter long-term market drivers, just the way the Arab oil embargo and the Iranian revolution contributed to years of high inflation in the 1970s and 1980s. However, there is limited scope for a long-drawn interruption to oil and gas supplies for three reasons. First, this would badly hit the Russian economy in the short term, which is very reliant on energy exports. Second, the US and Europe will want to avoid an escalation because of the damage to the economy it would incur, especially against the backdrop of high inflation. Third, Russia will not want to give Europe an incentive to plan for energy security without Russian gas. It would rather want the new Nord Stream 2 gas pipeline to Europe to proceed.
Hence, instead of geopolitics, it is better to focus on the oil market fundamentals to assess the medium-term impact on financial assets. The market remains structurally tight due to stronger-than-expected demand and depleted inventories after years of underinvestment. However, the global economy has become much less sensitive to oil prices – today, global oil consumption accounts for 3% of global GDP, compared with as high as 7% during the 1970-80s. While oil prices could still start to hurt demand at some stage, the stronger-than-expected US retail sales for January suggests we are not there yet (household income and savings remain strong enough to withstand high oil prices). Also, major OPEC producers such as Saudi Arabia and UAE have room to boost oil supplies in need. There is also signs of US shale producers restarting output. Meanwhile, reports point to progress in Iran nuclear talks; a breakthrough here would also boost oil and gas supplies. These steps should help keep supply-demand balanced this year.
Time to watch long-term inflation expectations, which have a close link to oil prices. Those expectations have remained within their decade-long range, lessening the urgency for the Fed to aggressively tighten policy. The Fed’s January meeting minutes showed policymakers were less hawkish than market estimates. There are also signs of some price pressures ebbing – the latest being lower-than-expected China producer price inflation (which have historically had a significant impact on US consumer prices with a lag). Thus, expect inflation pressures to subside by H2, reducing the pressure on the Fed to tighten policy significantly. This should keep risk assets supported. Energy sector equities have benefitted from the rise in oil prices and inflation; technical charts remain supportive for the sector in the near term.
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