Week ended February 25th, 2022
Any way you slice it last week was strange. For starters, the swings in sentiment were so sudden and sharp that they were impossible to predict, and the likelihood of getting caught wrong-footed was as high as I can ever recall. The main event was again Russia-Ukraine, where the week started with Russia declaring the two autonomous eastern regions of Ukraine independent followed by a full-scale Russian invasion, which is ongoing. Global equities sold off sharply early in the week (recall that Monday was a US holiday). On Thursday – following the start the Russian invasion – the S&P 500 went from 2.6% down early in the session to finish 1.5% higher by the close, a remarkable swing in the course of a single day. This reversal created momentum that carried through to Friday as investors moved back into risk assets, perhaps breathing a sigh of relief that the Russia-Ukraine saga would “progress as expected”, if that’s the right way to say it. If this is in fact the key underlying premise, then the base assumption is that the war will be contained to Ukraine’s borders. Is this a reasonable bet? I would certainly hope so unless Mr Putin is much bolder and less of a tactician than I think. Investors have had weeks to prepare for the inevitable, as President Biden and allies had more or less foretold Mr Putin’s every move, and perhaps this also led to what have been a relief rally once the constant warnings gave way to the actual start of the highly-anticipated and unjustified invasion of Ukraine. I really don’t want to dwell on this complicated geopolitical issue, but it’s hard to completely sweep it aside because it has been overhanging markets now for several weeks. For investors that are operating in markets (like the US) far removed geographically from this conflict, should the combination of Ukraine being taken by Russia (should that come to pass) and a significant expansion of financial sanctions on Russian institutions as a tit-for-tat cause so much turmoil across global financial markets? Russia, with a population of 144 million, is the world’s 11th largest economy ($1.6 trillion estimate for 2021), a mere 7% the size of the US economy (GDP of $22.9 trillion estimate 2021). Ukraine, with a population of 44 million, is the world’s 55th largest economy with 2021 GDP of around $155 billion. Russia’s economy is overall very dependent on the export of oil and gas, which accounted for an estimated 49% of Russian GDP in 2021 (source here). Of course, much of continental Europe has become addicted to Russian natural gas and oil, which arguably has led to less severe western sanctions so far on Russia than probably warranted. Russia’s per capita average income was just over $10,000/person in 2020, not far behind China’s; this is less than 20% of the per capita income of the United States and EU. Having said all this, Russia does have a strong military and is believed to have the largest nuclear arsenal in the world. If the war is contained, I can see limited tangible economic effect of this geopolitical nightmare on global financial markets, aside from adding further pressure on oil prices (a contributor to inflation). What are the broader risks of this geopolitical crisis then? The main ones that concern me are Mr Putin miscalculates by taking Ukraine and then pushing further west into a NATO country to test NATO’s resolve (unwise move), or that Ukraine launches missiles into Russia, a provocation that would almost certainly garner a faster and more systemic destruction of Ukraine. So long as surprises like these are avoided, investors can focus more on the things that matter in the global economy at the moment, namely addressing runaway inflation. In fact, we returned to this theme late in the week as Eurozone inflation was confirmed at a blistering 5.1% in January for the common currency bloc (see here), one more indication that global inflation is increasingly problematic and needs to be addressed soon.
There's one more thing I wanted to mention this week. I have expressed my view that investors should focus on the credit markets, since any sharp sell-off in credit assets (like corporate bonds) would attract the Fed’s, ECB’s or BoE’s attention much faster than equity volatility. I wrote about the corporate bond market a few weeks ago (here). Since then, credit spreads have continued to widen, really gapping out this week. The European high yield bond market was the worst affected either because (by definition) European high yield issuers are geographically closer to the epicentre of the Ukraine-Russia conflict (and hence more at risk of a spill over), or because as investors move out of corporate credit, it is the European market that becomes less liquid faster vis-à-vis US high yield. It’s hard say specifically what the issues are, but it is increasingly clear that the direction of travel of corporate bonds is down in price (up in yield), as both government bonds and risk assets remain under severe pressure. Keep an eye on this market. The last two tables of the section below contain corporate credit yields and corporate credit spreads, in case you want to look at the migration more closely.