Following sharp declines in January, global equity markets fell again in February on rising tensions between Russia and the West, culminating in the invasion of Ukraine by Russia on February 24. This occurred against a backdrop of persistently high global inflation data and changing expectations as to when and how much central banks will increase interest rates in 2022, which negatively impacted financial markets over the first month of the year.

Global equities, as measured by the MSCI World Index, fell 2.5 per cent in February and were 7.7 per cent lower compared to the start of the year. Value outperformed growth once again, but still fell 1.6 per cent for the month. Declines were heaviest across Europe, with the Euro Stoxx 50 down 6.0 per cent, while the Russian bourse was down over 40 per cent. In the US, the three major indices proved more resilient but were still lower in excess of three per cent for the month.

The US and European Union were quick to condemn Russia’s actions and impose sanctions against them. Although initially considered a bit light, sanctions have been ramped up to isolate Russia from the rest of the world. Sanctions include banning transactions with the Russian central bank, freezing assets, excluding some major Russian banks from the SWIFT international payment system, sanctioning some of Russia’s wealthiest elites, and the introduction of exports controls. Germany have halted the certification of the Nord Stream 2 gas pipeline from Russia to Germany, putting at risk the potential of large future foreign earnings for Russia.

These sanctions are expected to negatively impact the Russian economy and to severely limit its access to $600 billion in foreign reserves. In addition to a falling equity market, the ruble has depreciated significantly, plunging to a record low of less than one US cent, and Russia’s credit rating has been cut to “junk” status. The Russian central bank has had to increase interest rates from 9.5 per cent to 20 per cent to defend the currency.

At this stage, the clearest economic impact on the developed world is via food and energy prices. Russia is a significant exporter of commodities, including wheat, aluminium, palladium, gold and corn. Aluminium has reached record prices and the oil price rose to above $100 a barrel. Gold has also moved higher, finishing the month over $1,900 an ounce and recording a 6.2 per cent increase over February. The price of oil increased 11.5 per cent over the month and has risen 43.6 per cent and 66.5 per cent over the last three and 12 months, respectively.

Although it is early days, and it very difficult to predict geopolitical events, an initial assessment of the likely global economic impact is for a worsening of the economic growth/inflation mix. Forecasts for inflation are being revised higher and economic growth expectations trimmed. The impact will vary around the world with Europe most at risk.

This assessment is based on conditions that the conflict remains confined to the Ukraine, and the supply of gas from Russia to Europe remains open. The US has no appetite nor public support for sending troops to the Ukraine and engaging in a war with Russia. The situation is similar in the case of NATO. Nevertheless, they will both continue to supply arms and assistance to Ukraine.

The events in Europe have overshadowed an improvement in global economic data and a drop in Omicron cases globally. Manufacturing survey data improved across Europe in January, driven by a larger than anticipated improvement in the services sector with the negative impacts of the high Omicron cases easing. US consumer spending increased by a larger-than-expected amount in January, reflecting a bounce back from the Omicron impact from previous months.

Global inflation data remains elevated with the US core annual inflation rising to six per cent, the highest level on record for 40 years. The US Federal Reserve is expected to start increasing the Fed Funds later this month and follow this up with another three or four 0.25 per cent increases over the year. The Bank of England is also expected to continue to hike interest rates in the coming months while the latest events in Europe will likely make the European Central Bank more cautious and refrain from raising rates this year.

Clearly uncertainty is elevated at the moment. In times like this, it makes sense to have more moderately sized relative risk positions in portfolios. For the global economy, what happens to energy prices over the coming weeks and months is probably the most important thing to watch and in turn how central banks react.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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