US markets sink then rally in response to the Ukraine invasion
Despite potential inflationary pressures from the conflict, expectations for Fed tightening have been dialed back.
The shockwave triggered by Russia’s invasion of Ukraine spread across global financial markets Thursday, inflicting heavy declines on European stocks, but presenting a more mixed picture in the US where many companies are insulated from the direct impacts of the conflict.
After suffering early losses, US stocks rebounded, as technology stocks staged a small recovery from weeks of losses. Financials and consumer-defensive stocks maintained losses on uncertainty surrounding sanctions and a slowdown in consumer spending. Oil and gold prices rose.
Perhaps most significantly for US investors, the events in Ukraine have for now cooled expectations for an aggressive interest rate increase by the Federal Reserve in March, with more investors now leaning toward a 0.25 percentage point rate rise, rather than a 0.5 percentage point increase. That’s despite the potential for Russia’s actions to add more fuel to inflationary pressures.
At this point investors are left facing considerable uncertainty. As difficult as it can be to navigate the usual economic forces that buffet markets, geo-political risks are even more opaque.
“I can’t diminish the significance of what’s happening. It’s a dark day for Europe and it’s something that hasn’t happened in the post-World War II era,” says Andy Kapyrin, co-chief investment officer of RegentAtlantic, a Morristown, New Jersey-based RIA with $6 billion under management. “Russia will inflict a lot of damage on its neighbors and a lot of economic devastation on itself.”
“But this is a geopolitical event and while geopolitical events tend to result in a sea change in the world order they have little impact on economic fundamentals,” Kapyrin says. “History has shown, looking at the Cuban Missile Crisis, the fall of the Soviet Union, 9/11, that there is an immediate market reaction driven by the fear of the unknown, but markets tend to recover quickly because there’s not a lot of impact on major economic fundamentals, especially in developed countries.”
The immediate reaction Thursday was for the market to extend declines that began back in early January sparked by expectations that the Fed would be accelerating the timing and extent of rate increases to battle stubbornly high inflation. With the latest declines, U.S. stocks entered into official “correction” territory, a loss of 10% or more from their most recent high for the first time since the pandemic-parked bear market.
David Sekera, Morningstar’s chief US market strategist expected continued volatility in the short-term depending on where events in Ukraine lead. “The next step for the markets will be to evaluate the potential impact of the sanctions that the US and its allies will impose against Russia and gauge for any signs of further escalation or de-escalation,” he says.
But for investors in US stocks, Sekera notes that their portfolios are relatively insulated. US businesses generally do not have significant exposures to either Ukraine or Russia, he says, “so we do not expect much of a direct impact on US stocks from the sanctions.” However, he adds, “depending on the additional sanctions that are likely to be implemented, the risk to US stocks would be for heightened inflationary costs.”
James Paulsen, chief investment strategist at Minneapolis-based institutional research outfit Leuthold Group, notes there is a lot of emotion wrapped up in the impact of Russia’s invasion of Ukraine on the markets. But, he says, “I think this could be the final washout event of the correction.”
Paulsen points to a number of sentiment indicators showing investors have become particularly bearish on stocks, including the Chicago Board Options Exchange’s VIX index, which measures volatility, and the American Association of Individual Investors sentiment survey.
“I like the pessimism as a contrary indicator,” Paulsen says.
“Underneath this, there are extraordinarily good fundamentals,” he says. “We’ve had strong corporate results and I think that continues. Even with rates rising, they are still at very low levels around the world.”
Within the US stock market, technology stocks helped lead the rebound from early losses. Tech names, along with other fast-growing company stocks, have taken losses in recent weeks thanks to expectations of higher interest rates.
In the bond market, there was a muted response. Turmoil on the world stage often leads to a “flight to quality” where investors seek out the safe haven of US Treasury bonds. However, yields – which move in the opposite direction of prices – posted only limited declines.
There was movement in the bond market’s pricing for future rate increases from the Fed. After the most recent round of inflation and jobs data, expectations for a rate lift-off by the Fed in March became more aggressive , with expectations centered on a half-point rise in the federal funds rate, up from earlier expectations for a quarter-point increase.
Now, with the economic uncertainty created by Russia’s assault on Ukraine, the odds of a steeper rate increase have been pared back.
“Today’s events throw cold water on the extreme hawkishness expressed by some Fed governors,” says Ed Yardeni, president and chief investment strategist at Yardeni Research. “They will likely slow down the pace and deliver 25 basis points in March.” he says. Yardeni adds that he expects the Fed will delay reducing its holdings of bonds that it had purchased to pump money into the economy during the pandemic recession. Many market participants had expected that reduction – known as quantitative tightening – to begin in May or June.
Still, the outlook for the Fed is complicated by the potential inflationary implications of the Ukraine conflict. “Oil and agricultural prices are soaring after today’s invasion and there’s concern about exacerbated supply chain disruptions, particularly for palladium,” Yardeni says. He notes that Russia supplies 33% of the world demand for the critical metal, which is needed for catalytic converters in automobiles.
David Meats, Morningstar’s director of research for energy and utilities, doesn’t expect that additional sanctions will be implemented that would reduce the supply of oil or natural gas from Russia.
However, Morningstar’s Sekera notes that with oil and natural gas prices already high due to tight supply, energy sanctions on Russia would also have a detrimental impact on consumers and economies in the US and Europe. Russia and Ukraine are major wheat producers and the ripple effects of today’s military action may also drive food prices higher.
“Depending on how the situation in Ukraine impacts commodity prices such as oil and those inflationary pressures impede economic growth, the Federal Reserve will need to constantly re-evaluate the trade-off between the risk of further inflationary pressures and potential for higher oil and commodity prices to slow the economy more than expected,” Sekera says.