This article was originally published on franklintempleton.com by Stephen Dover.
Originally published in Stephen Dover's LinkedIn Newsletter Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.
Putting pen to paper on the outbreak of a war that is causing massive personal loss, grief and uncertainty is a huge personal challenge. My sympathies lie with all those suffering from these ongoing tragic events.
In our fiduciary role, however, we must also fulfill our obligation to our clients for dispassionate analysis of the implications of these events for their portfolios and financial well-being.
One of my favorite books is Peter the Great: His Life and World by Robert Massie. It describes how Peter the Great was instrumental in increasing Russia’s standing and influence in the world, as well as expanding its borders. It is helpful to have a long-term view on Russia’s history when looking at today’s situation, as it provides some context as to the ambitions of their leadership. There are some outcomes and implications in particular that are highly probable.
First, Russia is likely to face long-term adverse diplomatic, trade, financial and economic consequences based on its actions. This was a choice that does not enjoy widespread domestic support in Russia. Many Russians and Ukrainians are literally kinsfolk, and this path took the population by surprise. The shock is particularly acute for the middle-class Russians with aspirations for their families—they now face the prospect of international isolation and diminishing opportunity. The notion of Brazil, Russia, India, and China (BRICS) as the secular drives of global economic growth and investment returns had already lost much of its cache. Now, irrespective of the outlooks for the other three, Russia will almost certainly be excluded from any such investment designation so long as its expansionist policies remain a threat to regional, European, and global stability. Russian government debt and significant corporate securities will likely be severely restricted for global investors, both on account of US and European sanctions, but also because fiduciary considerations (governance) will not permit a return to the status quo. For investors, the lesson is clear—do not underestimate the likelihood of policy direction diverging from economic logic.
Second, a significant re-think of global security will need to be contemplated, particularly energy security. Russia is the third largest producer of oil in the world, the largest provider of natural gas to western Europe, and a leading supplier of other commodities.1 Ukraine is also one of the world’s three “bread baskets,” a major grains producer alongside North and South America. Nations that have relied on energy, food and other raw materials from Russia and Ukraine will now begin to diversify their suppliers. For example, the European continent relies on Russia for approximately 40% of its current natural gas requirements.2 Liquified natural gas is likely to be a significant alternative, and countries like the United States and Qatar would help fill the gap of reduced reliance on Russian supply. This shift looks to have already begun, as natural gas flows from Russia to Europe declined by 30% in first half of 2021 and 40% in the second half of 2021 relative to the same periods in 2020.3 Of course, the near term also matters for investors. Investors dislike uncertainty and until such time as warfare is replaced by diplomacy, markets will remain vulnerable to bouts of volatility.
Two factors will dominate the cyclical impacts on asset prices stemming from the conflict: its implications for inflation and growth. Those outcomes will, in turn, determine the response of central banks and the direction of interest rates.
In the near term, rising energy, food, and other commodity prices will push up headline inflation rates. Core measures of inflation—which exclude more volatile food and energy prices and are preferred measures for the Federal Reserve (Fed)— will likely follow higher. The pandemic, global supply chain disruptions, fiscal and monetary policy, and surging demand in 2021 have already unleashed strong gains in wages and prices, which make passing along higher energy and commodity prices more likely.
Recent comments by Fed officials indicate that they remain undeterred in their assessment that monetary policy needs to be tightened to slow inflation and prevent a persistent overshoot. It would likely take a significant adverse shock, such as a much larger decline in world equity markets and a corresponding reduction in investment and consumer spending, for the Fed to change its current assessment of monetary policy.
The challenge for the European Central Bank (ECB) is potentially much greater. Europe, as noted above, is reliant on Russian energy and to any disruption that might unfold due to conflict or sanctions. Accordingly, the ECB is not in the same position as the Fed. It must be more concerned about potential adverse demand shocks owing to uncertainty, as well as a potential adverse supply shock should energy supplies be disrupted. While the Fed, for now, can remain focused on inflation-fighting, the ECB almost certainly will proceed with greater caution.
Still, both central banks have their eyes focused on one common variable—inflation expectations. Market-based and consumer survey-based measures continue to expect inflation to average between 2.1% and 3.1% over the next five years. While this is still higher than the 30-year average for the actual Consumer Price Index of roughly 2%, it is much lower than the most report of 7.5%.4 If the conflict and sanctions produce not only higher commodity prices but a shift upward in inflation expectations, both central banks (and others) will be forced to hike rates faster at the potential cost of sharply lower growth or even recession.
Which brings us to the near-term investment implications. History is kind to the idea that conflict-induced selloffs are buying opportunities. We are not so sure. Even if a ceasefire and peace can replace war in Ukraine, a recovery in equities may not be sustained as above-average valuations, slowing earnings, and the triple specters of inflation, monetary policy tightening, and geopolitical uncertainty remain. Historical comparisons that suggest that the advent of conflict results in a buying opportunity are not always to be relied upon as the underlying conditions may be different. Those earlier episodes were not presented with today’s unique fundamental challenges.
Markets, in short, may enjoy a temporary respite on the hoped-for end of hostilities, but relief is unlikely to be long-lasting. Returns are fundamentally falling for other reasons, and volatility is apt to be more elevated. Rising interest rates and slowing earnings growth all but ensure that outcome, irrespective of what happens to geopolitical risk.
The medium-term implications for investors remain much as we’ve highlighted them before. As returns decline and volatility increases, diversification becomes paramount in our view. New opportunities also emerge. Over time, for example, higher interest rates might offer investors opportunities to re-engage certain fixed income markets for income as well as safety.
Finally, Russia’s invasion of Ukraine does not signal the end of global investing. Russia was never a major driver of globalization, whether in trade or finance. Asia and other emerging markets were always more important and remain viable long-term options. The strategic and climate-change drivers for massive investment if energy supply and distribution may have become even more important, for Europe, Asia, and many other parts of the world. The “R” in BRIC may be moving from upper to lower case, but the world and its capital markets will continue to offer investment opportunities.
For additional views from our Specialist Investment Managers, view Insights on current volatility. This will be regularly updated in the coming weeks.
Sources: IMF WEO, IEA, USDA, Blomberg
Source: Institute of International Finance.
Sources: University of Michigan, Federal Reserve Bank of St. Louis, BLS, Macrobond, Franklin Templeton Investment Institute Analysis. See www.franklintempletondatasources.com for additional data provider information.
What Are the Risks?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.