Global equity prices weakened a further 1.1% in February after a sharp 6.2% decline in January, as persistent global interest rate and inflation worries were joined by a new risk factor – Russia’s assault on Ukraine – that further undermined investor sentiment. Specific concern surrounded a potential disruption to Russia’s oil and gas exports, which led to a further 8.75% gain in WTI Crude Oil prices to $US95.84 a barrel.
The yield on U.S. 10-year bonds lifted by a further 0.05 percentage points to 1.83%, as continued high U.S. inflation reports maintained expectations of aggressive U.S. interest rate hikes this year. The US dollar was broadly steady during the month of February.
U.S. equity fundamentals – valuation challenges as rates rise further
Global equities are driven by U.S. equities, which in turn are ultimately driven by fundamentals.
The U.S. S&P 500 price index fell 3.02% last month, even though forward earnings rebounded by 1.6%. The nearer-term fundamental picture for U.S. equities remains mixed. On the positive side, current expectations still suggest 8% growth in U.S. forward earnings by year-end. That said, the period of earnings upgrades may now be behind us, as growth slows and interest rates rise. Earnings downgrades are a potential new risk for the market.
Based on Fed rate hikes, and notwithstanding the Russia-Ukraine conflict, we still see U.S. 10-year bond yields eventually staying above 2% during the course of the year.
Russia/Ukraine Conflict and Implications on Sector Views
Russia’s invasion of Ukraine, the biggest conventional military attack in Europe since World War II, has wide-ranging implications for economies and markets around the world. Notably, the conflict has increased commodity prices, which will likely keep inflation higher for longer. This can lead to broad turmoil mostly in the region but with implications across the entire world.
Russia represents only about 3% of global GDP and comprises just 0.3% of the MSCI All Country World Index. As a result, direct exposure to Russia’s economy and Russian equities is reasonably limited with the S&P 500 Index providing around 0.1% direct sales exposure to Russia. However, Russia produces about 10% of the world’s crude oil supply, making it the third-largest producer of global oil. Also, Russia produces 17% of the world’s natural gas supply. It is the world’s second-largest producer of natural gas and provides Europe with about 40% of their natural gas needs.
Because of Russia’s role in the energy space, oil and natural gas production can’t be replaced easily, which complicates a potential strategy of a full cut-off of Russian fuel. Bank of America expects Brent crude prices to increase to beyond $120 per barrel, barring any potential damage to infrastructure that affects output.
This conflict also presents risks to metals and food supplies, which will keep up near-term pressure on consumer prices. Russia is a big supplier of Palladium and Aluminium. Palladium is needed for automobiles, electronic components, jewellery, and dental fillings, among other products. While Ukraine is a major producer of Wheat and Corn.
As higher energy prices amplify inflationary pressures, they could dampen consumption and real economic growth. Europe is more exposed to these risks than the U.S. Limited income expansion in Europe relative to the U.S. over the past decade, coupled with a weaker Euro, makes higher crude and gas prices more painful for consumers. Currently, the EUR/USD is at $1.11. While U.S. consumers may be hit with higher energy costs, we expect in the short term a minimal impact on the supply side because the U.S. is energy independent. Higher for longer energy costs though would push out long-term breakeven inflation. And if it’s pushed out too long, then it could weigh on consumption and GDP.
From a corporate profit perspective, the S&P 500’s direct sales exposure to Russia is about 0.1%. So, the direct impact on American companies’ top and bottom lines is expected to be minimal.
However, the indirect implications are much more pronounced given how connected the U.S. is with Europe. Disruptions from this war and the higher energy prices that result could significantly dampen Europe’s growth outlook while weighing on corporate profits. Lower demand from European consumers could have an adverse impact on American profits, as Europe contributed about 14.5% of S&P 500 revenues in 2021. Europe is likely to have sufficient energy in the near term as winter comes to an end, but if restrictions continue into next winter, energy rationing is possible.
Putting it all in perspective, aside from commodities, Russia doesn’t play much of a role in the global economy. The U.S. doesn’t rely on Russia for components in the supply chain like it does with China. Using history as a guide, U.S. markets typically recover earlier from geopolitical events due to their safe haven status.
For positioning, we are ready for volatility as events unfold and are placing more of our focus on more defensive sectors of the economy. The Energy sector could see more upside, but exceptionally high prices are likely unsustainable in the medium to long term.
This article was written by the Standard Investment Bank’s Global Markets Department. For questions or clarification, please register your feedback below or send us an email to firstname.lastname@example.org