Russia’s invasion of Ukraine sent shockwaves through financial markets in February. Some of the impacts were predictable; Russian stocks and the Russian ruble nosedived, and gas prices spiked. Other impacts were less intuitive; on the day of the invasion, the Nasdaq jumped 3.3% as investors bet that the war would delay central banks hiking rates. Overall, it was a negative month for stocks and bonds, and positive for commodities such as oil and gold.
The Bank of England hiked interest rates to 0.5% early in February, as inflation rose again. Bond markets are implying rates to rise by 1.5% by year-end. Inflation is likely to continue to rise in the next few months, especially with the energy bill increase in April, but base effects should mean the headline rate begins to decrease come the summer. The UK stock market was one of the few positive areas in the month, boosted by high weightings to oil and mining. This acted as some good news against wider bad news, as we added weighting to our UK index tracker at the start of the month.
UK sanctions on Russian businesses and individuals could hurt the UK’s financial sector, which has seen a flood of Russian money over the last two decades. Bank stocks, which had risen on higher rate expectations, reversed their gains to end the month in negative territory.
The war in Europe highlights some of the attractions of the US market for investors; a huge, unified economy with self-sufficient internal demand, plentiful natural resources, and two oceans separating it from antagonists. However, its heavy technology weighting could be its Achilles’ heel, because long-duration stocks can be vulnerable to interest rate hikes.
Wall Street is expecting the Fed to hike rates nearly six times by the end of the year. Persistent inflation and higher yields have raised concern over corporate earnings, but the first earnings season of 2022 provided some comfort. American companies registered earnings growth of over 30% year-on-year. Despite this, concerns over the Ukraine war and tighter monetary policy hurt sentiment, and the S&P 500 fell by 3%. More domestically-focused, shorter-duration stocks did better, with our Threadneedle US Small Company fund bucking the trend to rise 2.2%.
Russia and Ukraine’s GDP and stock markets are small relative to the rest of Europe. However, the continent is vulnerable to any changes in commodity prices and supply. Europe imports 40% of its gas from Russia. Germany is particularly exposed. The impact stretches beyond energy; Germany’s car industry uses aluminium, which jumped to a record high.
Meanwhile, European banks have had to untangle themselves from contracts with Russian banks to avoid sanctions and face making loans with higher uncertainty. Away from its imports, however, Europe’s economy looks healthy, with the eurozone unemployment falling to 7.0%, the lowest since the bloc was created. This makes a good investment case for Europe if and when the Ukrainian invasion comes to an end.
Russia’s stock market plunged as investors absorbed the sanctions imposed by the West. Opec has so far resisted calls from the US to increase oil output, and oil prices have risen to over $100 per barrel for the first time since 2014. This is beneficial to the oil cartel – and Russia – but harmful to oil importers such as India.
China is one of the few large countries to not condemn Russia’s invasion, continuing a long policy of Beijing. Earlier this year, China had secured a 30-year gas supply deal from Russia. However, the country does seem to be quietly adhering to international sanctions, with China’s two largest banks placing restrictions on buying Russian commodities. China’s domestic economy is relatively insulated, and our Matthews Asia fund managed to eke out a positive return on the month.
Japan’s currency is seen as a safe haven at times of geopolitical strife, which provides a useful hedge to overseas investors like us. Our FTF Japan fund posted a 2.1% gain despite the wider market falls.
History shows us that equity markets usually bottom out at the start of a conflict and tend to recover afterwards. The caveat is that markets have struggled when the war has enduring economic consequences that damage corporate earnings, such as after the Yom Kippur War. So far, the energy supply has not been disrupted, because the sanctions exclude gas, but prices have still risen and any further rise would only add to inflation. The inflation dynamic has thrown a spanner into the works of the usual geopolitical shock playbook; usually, central banks would loosen policy but they cannot currently do this due to the high inflation environment.
We took steps last month to protect portfolios from inflation, which have paid off so far. We continually review portfolios to see whether additional steps need to be taken, but in the long-run market, volatility is the price investors must pay to earn strong long-term returns.