How do we price-in shifting probabilities and the variable scenarios of war?

The market has struggled to price in shifting probabilities of various economic scenarios resulting from the war in Ukraine. The result has been volatility; much of it to the downside. Early consensus beliefs about the Russian invasion of Ukraine and the West’s response were dashed within days. The economic sanctions by the West came in stronger, faster, and more unified than markets originally anticipated, and the Ukrainian resistance and Russian military hurdles have both proven formidable. Self-sanctioning actions by Western companies have also led to certain Russian commodity exports facing constraints in reaching the global market. Given Russia’s position as a major commodity exporter – from energy, to agriculture, to metals – the already tight commodity markets faced price spikes at a time when inflation was already raging.

From the primary humanitarian perspective, the focus is on achieving peace and a negotiated agreement for Ukraine. From the perspective of impact on global markets, the focus is on the sanctions regime – whether it will escalate or de-escalate, and how long it will remain in place. Military strategists point to an impending assault on the Kyiv, the capital of Ukraine, despite Russia’s early military setbacks. How the West responds to what is likely to be a fierce battle could point in one direction or another for the longer-term sanctions outlook. The longer and more severe the sanctions, the more difficult the inflation outlook is likely to be.

While we do believe that at some point President Putin desires a negotiated settlement with assurances for Ukraine’s future non-NATO status, the events on the ground are likely to have a significant impact on scope and depth of ongoing sanctions. While Russia is suffering economically from this war, it does have available retaliatory economic measures such as restricting targeted exports that could disrupt global markets and lead to even greater tit-for-tat economic measures. As has been widely reported in the media, Putin has already stated that the economic sanctions imposed by the West are “akin to a declaration of war.”

Of course, the expected peace negotiations and sanctions will be closely intertwined and de-escalation of sanctions would probably only happen in conjunction with sooner than anticipated peace negotiations. We believe the global markets can adapt to the current sanctions regime and inflationary pressures would peak and then moderate in the coming months. A strong escalation of sanctions, however, would lead to a longer period of inflation pressures and curtailment of global growth. The U.S. economy continues to have strong and balanced fundamentals that are highlighted by a healthy labor market. The economy is in a position to withstand quite a bit of turbulence but could still succumb to a full-blown disaster scenario if inflation stayed high and damaged consumer and business spending.

Recognizing that the global economy faces heightened uncertainty and a growth headwind, the Fed may soften its trajectory for interest rate increases – at least during this acute phase of the war. The inflation pressures, however, continue to compel higher interest rates this year and the main question is pace and timing. The Fed is in a tight spot, however, because the nature of inflation driven by severe supply shocks means that the Fed’s tightening – unless it were extreme – would have only a small effect on the inflation trajectory. At present, the most likely course by the Fed looks to be gradual increases in interest rates throughout the year that include instances of half percent jumps. By year end, short-term interest rates are likely to be near 2%.

The war in Ukraine has made an already difficult-to-navigate year all the more challenging for investors. Prior to the Ukraine invasion, we had expected the U.S. economy to perform well even in the face of rising interest rates. Stock market valuations were elevated which pointed to stock market returns being somewhat below the level of corporate earnings growth to allow for valuation compression. While this “base case” still exists, the tail risk has risen substantially and economic developments from here are intertwined with a much stronger than usual geopolitical consideration. 

We do believe that among major global markets, the U.S. is better positioned than either Europe or emerging market economies. The U.S. economy is more insular than other economic regions, is not in the economic crosshairs the way Europe could be if developments in Ukraine spiral downward, and can weather inflation pressures much better than smaller emerging market economies. The current environment is unfortunately one in which fixed income – except for the safest, shortest-maturity securities – also faces difficulty and is unlikely to provide the type of inverse returns in a portfolio as is usually seen at times of equity market stress. That headwind for bonds comes from the expectation of further interest rate increases – both short-term rates that the Fed effectively “controls” and longer-term rates that are more market driven.

It is important to remember that the equity market is a discounting mechanism and the recent volatility is an attempt to price in the future impacts of these various potential outcomes and their probability of occurring. The stock and bond market headwinds to begin the year were primarily in response to the Fed laying out a more aggressive path for interest rate increases for the coming year. That trajectory was already priced into the markets when the invasion of Ukraine began, and it is the “new” information that will push the markets in one direction or another.

The present high degree of uncertainty means that economic and market prospects six months from now could turn out to be notably better or worse than the market is currently envisioning. At times of high uncertainty, market participants often grasp at headlines and reposition abruptly. We prefer to identify the driving factors and consider how these are developing. As outlined above, the potential for a tough sanctions regime to exacerbate inflation pressures is a key issue, as is the Fed response. Going forward, these developments could point in the same direction in a positive way, the same direction in a negative way, or offsetting directions. We do not believe the Fed will “bail out” the markets from a decline, but its messaging will be important. Nonetheless, political considerations in Washington and Europe will also play a major role in setting the course of sanctions, and a considerable degree of influence rests with actions decided by President Putin himself.

Netting all of this out is difficult and we now consider the odds of a U.S. recession over the next 12 months to be near 20%. That is an important consideration because large and protracted equity market declines are almost always associated with impending recessions. Even with our base case of avoiding a recession, however, the market headwinds will not completely go away and it is clearly a year for moderate expectations as far as investments are concerned.