Financial markets continue to be rocked by events in eastern Europe. However, recent developments suggest that Russia and Ukraine may be making some progress. Talks are shifting into “more realistic” territory, according to Ukraine’s President Volodymyr Zelensky, while Russia’s Sergey Lavrov has hinted that some form of compromise may be possible: neutral status for Ukraine (one of Russia’s key demands) now appears to be on the table.
Vladimir Putin has also referenced security guarantees for Ukraine, but without NATO enlargement. The idea of a demilitarised Ukraine with its own army has also been evoked – similar to that of Austria or Sweden.
Meanwhile, across the Atlantic, Joe Biden has ratcheted up the rhetoric and gone so far as to qualify Vladimir Putin as a war criminal, comments that have outraged the Kremlin.
In Ukraine itself, the humanitarian tragedy continues, with repeated assaults on numerous cities and further loss of life.
Boris Johnson believes that Ukraine is paying the price for the West’s manifest failure to understand the threat posed by Putin, adding that the EU should never have continued to treat Russia as a member of the international community after its annexing of the Crimea in 2014.
The UK, the US and the EU, together with nation states across the world, are continuing with their efforts to cut off Russia’s access to global capital markets and limit Moscow’s enjoyment of certain technologies. The result is a crashing Russian economy, a relatively worthless stock market and a currency in freefall on the foreign exchange market. Whether or not a settlement is reached, both the Ukrainians and Russians face years of hardship.
NATO members have reiterated their refusal to engage in any military action: establishing any kind of no-fly zone over Ukraine would, they say, run the risk of escalating things considerably. Instead, NATO and its allies have resorted to the severest sanctions ever seen on Russia and its people.
While these have primarily targeted Moscow’s financial, defence and intelligence sectors – together with the country’s oligarchs – the US has also placed a ban on the use of Russian oil. This has significantly pushed up the price of energy, causing repercussions which have quickly fed through to the global economy and the consumer.
Central banks around the world are fully anticipating a new wave of inflationary pressures created by further rises in energy and raw material prices. This could see inflation peak at around 8%, before dropping back to around 5% and then finally normalising at between 2.5% and 3% – significantly nearer to the central banks’ 2% target. Nevertheless, inflation would still be double that to which the financial markets and consumers have become accustomed (while they manage lower investment returns and increases in household costs).
On Wednesday, as part of its drive to tackle rising inflation, the US Federal Reserve Bank approved its first interest rate hike in more than three years (0.25 basis points). Further rate hikes, it says, will be agreed at each of the remaining six meetings this year, suggesting a consensus fund rate of just under 2% by the end of 2022. The committee also envisages three more hikes in 2023, but none the following year.
The Federal Reserve Bank also tempered expectations of economic growth this year, while sharply raising its predictions for inflation, which is currently sitting at a 40 year high. There is every likelihood that it will remain elevated, reflecting supply and demand imbalances created by Covid, high energy prices and broader price pressures.
On Thursday, the Bank of England announced a further interest rate increase from 0.5% to 0.75%, putting it on target to peak at around 2% a year from now, where it is expected to remain until the end of 2023. This is the third increase in four months and comes at a time when UK inflation has hit a fresh 30-year high. At 5.5%, it is well above the 2% target rate. The Bank’s policymakers cited rising prices and strong employment as the reasons for the latest rise. Although expected, this was not good news for households.
In Europe, the European Central Bank surprised the market and its investors by announcing it could end its asset purchasing programme in the third quarter, rather than at the end of the year. It also said that Russia’s invasion of Ukraine was a “watershed moment for Europe” and that it would take whatever action was needed to safeguard financial stability.
As is the case in other parts of the world, inflation in the eurozone is expected to reach 5.1% by the end of the year. But the European Central Bank is unlikely to adopt a particularly aggressive interest rate policy, preferring instead a more gradual approach (given the current levels of uncertainty across the EU and in Eastern Europe).
Equity markets have shown a measure of resilience over the past few days. They have moved up from their recent lows, which was to be expected – given the beating that they have taken over the first quarter of this year. They were further buoyed by news that Russia and Ukraine may be en route towards something of a compromise.
But the stock market is not the economy… and one swallow does not a summer make. With inflation being propelled by high energy and commodity costs, economic growth faltering and the threat of stagflation ever-present, this is no time to be complacent about a few days of (relative) euphoria. Indeed, it is probably time to reflect on what lies ahead.
Whatever the outcome in Eastern Europe, the global system does not appear particularly stable at the moment. Indeed, many historians and academics have compared it to the way it was in the period leading up to 1914. That does not leave anyone able to sleep easy.
We also appear to be entering a period of having to simply accept higher interest rates and inflation. The backdrop to all of this is the urgency with which global warming needs to be tackled and the need to adopt an investment programme geared towards increased use of renewables and significantly less reliance on fossil fuels. Portfolio positioning over the coming years will therefore be very important.
If we have learned anything from the last couple of decades, it is that global crisis points seem to be coming about more regularly, making life difficult for governments, central bankers, market traders and investors. That said, we continue to believe that a sensible asset allocation will generate acceptable investment returns adjusted for inflation over the longer term. Regrettably, some of the aforementioned crisis points (such as the pandemic and the tragedy unfolding in Eastern Europe) can only be classified as unknown unknowns. Such factors will inevitably create short-term disturbances across most asset classes.
We are experiencing more uncertainty and volatility in financial markets than ever before. They are simply not immune to events such as an Eastern European country being invaded. Since the outcome is impossible to predict, we can only focus on the long-term effects that it is likely to have on the global economy, inflation and central bank policy.
Within our investment process and asset allocations, we continue to focus on four important pillars: quality growth, value, global income and innovation. Each of these constitutes a powerful driver of performance over the long term. As far as the short term is concerned, always ponder before making a move. Whether you are buying or selling… never do so in haste.