U.S. equities finished the week higher after the S&P 500 staged a 3.74% rally on Thursday and Friday, despite moving lower earlier in the week amid the ongoing conflict between Russia/Ukraine.A number of sanctions aimed at the financial health of Russia were levied by world leaders, with the goal of maximizing the most economic damage in both the short and long-term.Among these was the removal of some Russian banks from SWIFT, an integral part of exchanging funds.Growth names outperformed value as the geopolitical tensions reduced the probability of an outsized rate hike by the Federal Reserve. Odds of a 50bp hike fell to 14%, down from 81% just 2+ weeks ago.WTI crude settled up 1.5%, above $91/barrel, but off best levels of $100.54 (seen Thursday), due to ongoing supply issues which will be exacerbated amid the ongoing conflict given Russia’s influence on the global oil market.Even as equities have sold off to start the year, investors have not seen any capitulation according to BofA’s Flow Show Report. Money managers in aggregate reduced their equity holdings by one third in the prior two weeks according to the National Association of Active Investment Managers. Exposure to equities fell to 44%, a level seen in 2020.The VIX surged on Monday and posted its highest monthly average since October of 2020 while yields declined as treasuries were bid up in a flight to safety.The Swiss Franc staged its biggest gain against the Euro since 2018 and gold held near the more than 13-month highs it touched last week.After falling into correction territory (Decline of 10% or more), the S&P 500 has averaged a staggering 24.8% return one-year post entering correction territory and is also higher 90.3% of the time.European natural gas surged 10% on Monday after another round of international sanctions on Russia.In Germany, Chancellor Olaf Scholz announced that defense spending will be raised to 2% of GDP going forward, in line with NATO demands.South Korea is exploring banning exports of strategic items to Russia. The government will soon make a decision of non-strategic goods.
Despite the whipsawing headlines throughout the week, U.S. equities actually finished higher with the S&P 500 gaining 0.82%, snapping its two-week losing streak. Other U.S. benchmarks also finished higher, with the exception of the Dow Jones which finished largely flat (-.027%). Indexes reversed losses seen on Monday and Tuesday with a big Thursday and Friday rally in which the index gained just under 4% over the final two trading days. The rally came as sanctions imposed on Russia were less draconian than originally expected, paired with the possibility for a more dovish Central Bank outlook.
The week was a wild one, with geopolitical headlines dominating the narrative following Russia’s invasion of Ukraine, which ultimately was the key factor in the week’s price action. With the narrative evolving on a second-by-second basis and the world watching, we will briefly touch on a number of what we believe are the most important sanctions that have been handed down thus far:
The United States and its allies moved to block certain Russian banks’ access to the SWIFT international payment system (This was seen as the harshest sanction thus far and will limit Russia’s ability to process international payments) which could lead to missed payments and giant overdrafts within the international banking system.The U.S. Department of the Treasury targeted the “core infrastructure” of Russia’s financial system, sanctioning two of its largest banks – state-backed Sberbank and VTB Bank. Also on the sanctions list are three other large banks and certain senior executives.Officials in Washington added VTB, Otkritie, Novikombank and Sovcombank to the Specially Designated Nationals (SDN) list. The move effectively kicks the banks out of the U.S. financial system, bans their trade with Americans, and freezes their U.S. assets.Imposed restrictions on a number of goods including semiconductors, telecommunication, encryption security, lasers, sensors, navigation, avionics and maritime technologies”.Sanctioning on some of President Vladimir Putin’s closest allies, including the freezing of their assets, and the ability to travel globally. The UK, France and U.S. announced they will continue to target oligarchs’ houses and yachts, specifically.EU officials announcing restriction of their airspace to all Russian aircrafts and will ban state owned media companies Sputnik & RT.U.S. and other EU nations have also stopped all major Russian companies, as well as, the Central Bank from raising financing in their respective markets.The UK also announced they will not provide port access to Russian ships.Halting the certification process of the Nord 2 pipeline running from Russia to Germany.Japan and others are set to freeze Russian Central Bank Forex assets, while Canada has announced plans to bank Russian crude imports.Norway currently undergoing the process of dropping Russia from its Sovereign Wealth Funds.
MARKET PRICE ACTION
With the risk-on tone, growth outperformed value on the week with many believing the escalating geopolitical conflict may cause Central Banks globally to re-assess their plans to raise benchmark rates at a slower rate than initially thought. Following the invasion, odds for a 50bps hike in March fell to 14%, which is down from 81% more than two weeks ago, and helped spur a significant rally in growth stocks. Most defensive plays underperformed, but from a sector standpoint there were not many themes to be noted.
Instead, various sub-sectors saw certain pockets of strength which included, Industrial metals, hospitals, pharma, biotech, infrastructure, cyber security, semis, Aerospace and Defense and Energy.
WTI crude settled up on the week by 1.5%, just above $91/barrel, but did finish well off Thursday’s peak of $100.54. The price moves in both crude and brent oil have been some of the most volatile in years. So far this month, Brent futures have moved by $3.25/ day, which includes a run of 11 consecutive days with intraday swings of more than $2, the longest such stretch in almost two years. Given world reliance (to some degree) on Russia’s energy sector we expect the volatile swings in commodity markets to continue for quite some time.
Treasuries were weaker with the yield curve continuing to flatten while the dollar was stronger against major crosses. Ruble weakness was the main FX story of the week after it fell to new record lows following sanctions.
Even with the rally on the week, indexes still remain well off their all-time highs seen late last year and early this year. With stocks coming under pressure and geopolitical tensions ramping up, money managers in aggregate reduced their equity holdings by one third in the prior two weeks according to the National Association of Active Investment Managers (that tracks investment advisers from 125 firms). While investors have yet to see capitulation in equity positioning according to Bank of America’s weekly flow show report, exposure to equities in the survey mentioned above fell to 44%, a level last seen in the spring of 2020. In the absence of capitulation, it appears that “bad news” is more so priced in to current equity index levels than not.
Vladimir Putin announced the beginning of a “special military Operation” on Thursday morning that began with missiles impacting several sites across the country of Ukraine, followed hours later by ground forces crossing into the country at multiple locations. Over the last four days, Russian forces have been limited in their successes, with the main surprise coming in Ukraine’s capital of Kyiv, which has seen civilians take up arms to defend their country.
Regardless of the results of the conflict, markets seemed able to stomach some added uncertainty in commodity markets and a further increase in energy pricing. Long-term, the shortage of key Russian commodities primarily Crude oil but also Nickel, Aluminum, and precious metal Palladium, (Norilsk Nickel in Siberia produces at around 30% of the world’s supply), could produce supply chain bottlenecks even without retaliatory sanctions from Russia’s government. Western Powers, at this time, have not restricted access to oil and energy products with these sanctions and still plan to use Russian natural gas for the foreseeable future.
Even as geopolitical conflicts bring an enormous amount of uncertainty to investor’s doorstep, generally price action in U.S. equity markets is positive in the months and years to follow. With a number of wars listed below, the U.S. stock market went positive in the months following the beginning of war (with the exception of the Afghanistan war, which also in large part connected to the 2000 dot come bubble).
After falling into correction territory (Decline of 10% or more), the S&P 500 has averaged a staggering 24.8% return one-year post entering correction territory and is also higher 90.3% of the time. Over a two-year period, the S&P 500 has been higher 86.7% of the time and averages a 37.4% return off the lows.
America’s involvement in the Russian/Ukraine conflict is more indirect at this time with no U.S. soldiers on the front lines. However, we continue to monitor and assess the ever-changing investing backdrop so that clients can be positioned in a way that we believe will allow for them to meet their long-term strategic goals. Despite trying to summarize the ongoing conflict, given the very fluid dynamics of the situation, we believe this is a great overview of the struggle.
ENERGY AND COMMODITIES
Despite Russia’s small direct impact on the U.S. market, Europe is very involved with the Russian economy and receives about 40% of its natural gas and 25% of its oil from Russia. The Primary risk of a Russian market disruption is concentrated within the energy and commodity sectors.
In the case of energy, Europe has few short-term substitutes for its energy needs and is likely to depend much more heavily on U.S. imports to help offset the loss and maximize damage to the Russian economy (Oil & gas accounted for 60% of Russia’s exports and 39% of federal budget revenue in 2019). Ultimately, the effect may be felt by U.S. consumers at the pump as the price of oil continues to move higher.
While there have been some comments by President Biden in the past stating that the U.S. could coordinate the release of strategic reserves with other countries, that would only have a limited effect given the number of reserves and current undersupply. Adding to oil’s upside momentum is Iraq, which halted output at two fields that can pump almost 500K/barrels a day between them, only exacerbating the supply side of the equation. Even as OPEC+ is scheduled to meet this week, expectations are for the cartel to stick with their current plan of gradually increasing oil production, doing little to help the undersupplied market.
With Energy costs on the rise amid the geopolitical turmoil, there have been more discussions about the potential effects regarding higher inflation in the U.S., which could force the Fed and other Central Banks to tighten more than markets currently expect, as rate normalization get underway. The faster tightening is not expected right away but may come as the global economic impacts of sanctions are better understood.
Stocks almost erased their losses on Monday as traders assess the latest developments following a wall of sanctions (mentioned earlier) against Russia. The NASDAQ and Russell 2K closed higher on the session while the S&P 500 and Dow Jones trimmed most of their earlier losses. With February closing out, the S&P 500, Dow Jones Industrial and NASDAQ Composite all declined for a second straight month, the longest losing streak since October 2020.
The VIX surged on Monday and posted its highest monthly average since October of 2020 while yields declined as treasuries were bid up in a flight to safety. The Swiss Franc, a safe Haven asset staged its biggest gain against the Euro since 2018 and gold held near the more than 13-month high it touched last week. Oil which jumped over 4% on Monday, but finished off best levels, advanced after the U.S. and allies have discussed potentially releasing about 60MM barrels of crude from emergency stockpiles to quell supply fears, although the move will only help temporarily if the conflict is prolonged.
As world leaders condemn President Putin’s actions, they have rushed to take a number steps to deter additional escalations from his regime.
Following sanctions, Russians lined up around the country to withdraw funds amid concerns the Ruble would continue to free fall, which was down over 30% when trading opened on Sunday night in FX markets. The Ruble, being quoted at 110 to 120/dollar by Russian Banks had traded at 75 before the invasion.
With the devaluing of the currency, estimates show this could add about 5% points of inflation, which had already climbed to just under 9% in January, and was more than double the 4% target the Central Bank was trying to maintain. As the Ruble collapsed, Russia’s Central Bank raised lending rates to 20% to try to spur inflation and provide some stability to the currency.
While the fallout in U.S. markets was limited, shares of Russian companies cratered in the U.S. and London after Moscow’s market went dark and closed on Monday and Tuesday. Sberbank’s depositary receipts sank a record 74%, retailer Magnit slid 80%, and Gazprom dropped 53%.
The Bloomberg World index dropped 0.67% amid escalation of the Russia/Ukraine war. Western allies appear to be unified to impose sanctions on Russia. Geopolitics uncertainty is causing massive upswings in volatility as investor reshuffle their tactical asset allocation. Gold continues to shine as real yields decline. The Dollar index rallied last week ahead of the Fed policy update to Congress. OPEC+ will hold a crucial meeting this week, but the consensus is that they will stick to original plan despite political pressure to increase output.
European natural gas surged 10% on Monday after another round of international sanctions on Russia. This weekend, western nations agreed to exclude some Russian banks from SWIFT to further isolate Russia from global trades. The European Union is considering additional penalties on state company executives as well as banning Russian flights. In Germany, Chancellor Olaf Scholz announced that defense spending will be raised to 2% of GDP going forward, in line with NATO demands. Bank of Russia doubled its benchmark interest rate to 20% in an emergency meeting on Sunday as the ruble plunged 30%. The DAX index dropped 3.16% last week, while the CAC 40 index decreased 2.56% during the same period.
Last week, European Central Bank (ECB) President, Christine Lagarde, said that she is monitoring the situation in Ukraine with ECB members and that it will be taken into consideration at the next policy meeting. She added in an official statement that “The ECB will ensure smooth liquidity conditions and access of citizens to cash. The ECB will implement the sanctions decided by the EU and the European governments. The ECB stands ready to take whatever action is needed to fulfil its responsibilities to ensure price stability and financial stability in the euro area.” The Euro STOXX index dropped 2.63% last week, with banks down 8.52%.
The Brazilian government posted record monthly budget surplus in January of $19.8 billion due to strong tax revenues. President Bolsonaro is exploring the idea of releasing another stimulus package ahead of October’s presidential elections to offset rising fuel costs. Mid-month consumer prices rose 10.76% year-on-year in February, slightly above the consensus estimate of 10.63%. This print makes Central Bank’s monetary policy decision harder, as previous rate hikes had negligible effects on inflation. If the government gets a fiscal package approved through Congress, monetary tightening could be counterproductive. In January, net debt was 56.6% of GDP, down from 57.3% in December. Improving public finance keeps attracting foreign investors and boosting the Brazilian Real. Brazilian stocks gained 0.23% last week
In Japan, factory output contracted for a second straight month in January amid supply shortage. Automakers, iron and steel manufacturers led the decline according to Japan’s Industry ministry. Retail sales fell 1.9% month-over-month as consumer confidence declined to a five- month low. Prime Minister Fumio Kishida addressed the parliament and reaffirmed his ambition to implement “New Capitalism” policies. According to him, “Capitalism isn’t sustainable unless it is something that belongs to all stakeholders. From that point of view, it is important to accept that the fruits of growth are flowing to shareholders, and to think about that situation.” Kishida’s administration is exploring raising taxes on capital gains and regulating share buybacks. The July upper house election will be crucial as a defeat will cut short his tenure as a Prime Minister. The NIKKEI 225 dropped 1.95% last week.
In South Korea, The Markit Manufacturing PMI climbed to 51.90 in December from 50.90 a month earlier. According to survey provider IHS Markit, “The final round of 2021 survey data epitomized the supply-constrained narrative we’ve seen develop this year. Given South Korea’s prominence in the automotive and electronics industries, substantial improvements in global supply chains will be required before we see a meaningful acceleration in manufacturing growth.” Exports grew 18.35% year-over-year, moderating from a 32% annual surge a month earlier. The KOSPI index declined 0.76% last week, with services down 7.71%.
South Korea is exploring banning exports of strategic items to Russia. The government will soon make a decision of non-strategic goods. Furthermore, South Korea decided to release its strategic oil reserve and consider resale of LNG to Europe to help with the energy crisis. It will also participate in the SWIFT ban and provide humanitarian aid to Ukraine. The SWIFT ban already has collateral damage as some Korean shipyards are worried Russian clients may miss payments. Bank of Korea is expected to pause its tightening cycle following three rate hikes since August. The CPI decreased from 3.7% in December to 3.6% year-over-year in January. Korean stocks declined 2.47% last week.
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