- Economic recovery likely undeterred: Rising energy prices add risk to Europe’s recovery but are unlikely to derail the global economic recovery.
- Expect further equity volatility: We see the strongest impacts in commodities, energy and financials, but focus should shift quickly to interest rates and supply-chain resolution.
- Seeing value amid spread widening: We believe the impact of Russia’s actions on fixed income markets has largely played out, and any further widening in credit spreads could present opportunities.
A new phase of geopolitical uncertainty begins
As the tragic events in Ukraine unfold, one thing is clear: Russia’s willingness to use military force to redraw national borders and expand its sphere of influence flouts international law and sets a dangerous precedent. China is watching closely and thinking of its intentions for Taiwan. The rest of the world is watching too, gauging U.S. and NATO resolve and recalculating what may lie ahead. The intensions of the invasion remain uncertain, but the outcome is likely to have major repercussions on Europe’s political and economic landscape in the coming decades.
Economic recovery likely undeterred, but energy prices a growing concern
Europe’s economy will likely feel the brunt of the impact through higher energy prices, feeding through to higher inflation, squeezing consumers’ disposable income and potentially curtailing spending. We believe continued economic reopening from the pandemic should maintain the region’s positive growth outlook, but the inflationary impact could increase the marginal risk of a European recession.
Although the United States does not have the same level of energy dependence on Russia that Europe has, ripple effects in global energy markets are likely to drive gas prices and other input costs higher, exacerbating U.S. inflation pressures. Still, we believe strong demand – particularly with U.S. consumers’ pent-up savings – make it unlikely that the conflict will materially alter the current trajectory of solid but slowing economic growth and persistent but moderating inflation.
Should the conflict persist, it likely would lead to further tightening of financial conditions, slowing economic growth at the margins, and less scope for a “soft economic landing” rate-hike scenario. The conflict is unlikely to deter the Federal Reserve from raising interest rates over the course of this year. While there is still plenty of time for new developments to alter the outlook before the March 16th FOMC meeting, at this juncture, we see a 25 basis points (bp) rate hike is the most likely scenario, rather than a 50 bp hike as some investors had previously expected.
Further volatility in equities likely despite little corporate exposure to Russia
The U.S. dollar is likely to strengthen as a result of war tensions. Dollar appreciation, coupled with more acute economic effects felt internationally, could adversely affect multinational corporations with meaningful European exposure. Overall, the U.S. is relatively insulated from direct impacts of the conflict, and U.S. corporations earn little revenue from Russia.
U.S. equity markets could remain volatile in the near-term, with the strongest impacts most likely in sectors such as commodities, energy and financials. The consumer discretionary sector could be affected indirectly by higher interest rates and inflation. Equity market weakness potentially could persist until there is greater clarity on Putin’s intentions and the impacts of sanctions. This will refocus investors on the path of interest rate hikes and easing supply-chain pressures, which will determine the appeal of cyclical equities relative to growth equities. If U.S. inflation starts to roll over in the second quarter, as we expect, we would view that as a positive for equity markets.
Further spread widening in fixed income could be an opportunity
Bond yields have declined significantly in recent days amidst a rally in Treasuries. However, we believe most of the conflict’s impact on fixed income markets has already occurred. Sanctions imposed on Russia have been less strict than expected. With Omicron receding and Covid issues cresting, the backdrop for economic growth remains constructive. Volatility may persist, but Russia is unlikely to remain the defining market risk for long. That said, any further widening of credit spreads could present select opportunities.
We are closely monitoring potential impacts on European securities in Voya strategies, but our exposures to Russia and Ukraine are extremely small. We may see greater demand among European investors for U.S. Treasury securities, although this should have little effect on other fixed income sectors.