Why the war in Ukraine could embolden central banks to double down on inflation
The Russian invasion of Ukraine continued to ratchet up this weekend, with Russian forces flouting a ceasefire to allow Ukrainian citizens to escape besieged areas. The weekend reports suggest that Russian troops continue their march towards Kyiv, the capital of Ukraine. We begin a new week where this war is as brutal as ever, for now the Ukrainians are holding on to their key cities and President Putin has not secured a victory, however, if there are signs that either 1, Vladimir Putin is considering a nuclear option to get the job done, 2, NATO and the West intervene to physically stop Russia from attacking the Ukraine or 3, the capital city Kyiv falls to the invaders, then sentiment is likely to drain further across all asset classes. The impact of war on European asset prices is clear: the FTSE 100 has tumbled to its lowest level since September 21, the Dax is at its lowest level since November 20, the S&P 500 is back at June 21 lows. Bitcoin is also worth watching, it has been extremely volatile in recent days and is not yet proving itself to be a safe haven for the sanctioned dollars of Russian oligarchs. Not even a stellar labour market report from the US could give comfort that the world’s largest economy is in good shape as it faces this latest crisis.
Why World War Three is an unlikely scenario
Assessing the latest news, we continue to think that a world war is a low-risk scenario. If NATO were to impose a no-fly zone over the Ukraine this is only likely to happen once an official cease fire has been declared. A world war, with the West against Russia is, unsurpsingly, our worst-case scenario for financial markets. However, more likely at this stage is an escalation in the fighting between Russia and Ukraine, with the next major event to watch out for being the battle for Kyiv. We would expect that once Russian forces descend on the capital of Ukraine, it will be a fierce and bloody battle for the centre of power in this country. If the Russians overpower a brave resistance from Ukraine and overthrow President Zelensky, this would be another red flag for investors to ditch risky assets, and we would expect further large losses for stocks, with commodities surging once more, especially wheat and corn. If Ukraine does fall to Russia in the coming weeks, then one has to assume no exports out of Ukraine for the foreseeable future, as potentially a Ukraine under Russian control would also face sanctions from the West? This means more commodity price inflation for longer.
The financial impact of martial law in Russia
Overall, the situation remains grim. The risk is that after failing to win an easy victory and with the war now going into its 12th day, Putin will increase troop numbers and firepower to bring it to an end sooner rather than later. This is likely to keep investors on red alert. We have spoken in the past that if this conflict is to drag on, then financial markets could get used to the new normal, however, we don’t think that investors’ consciousness is ready for that at this moment, and thus volatility is likely to remain elevated for some time. Another red flag for financial markets could be the declaration of martial law in Russia, to quieten protests about the conflict at home. President Putin has denied that he will impose this, however reports suggest that protestors are already facing brutal force from Russian police. If martial law is declared in Russia, we believe that this could lead to another swoon lower for risk assets as the markets would need to digest Russia returning to a period before the end of the USSR, which would cement its ejection from Western financial markets potentially for many years or decades to come.
Watch luxury goods at the start of a new week
The question is, how much more selling has to take place? There have already been huge losses for the rouble and European -based companies with Russian links. For example, Renault, which is down some 25% since the conflict began due to its ownership of Russia’s biggest car company. Carlsberg has also fallen more than 15% due to the brewer having to close its breweries in the Ukraine on the back of this conflict. We will also be watching the performance of luxury goods and consumer stocks on Monday, after there was a wave of companies that “temporarily” closed their Russian operations at the weekend, this includes Burberry in the UK. The Burberry Group saw its stock slump more than 8% on Friday, due to the importance of Russia to sales of luxury goods in recent decades. The loss of this market and the oligarch’s dollar could see further losses for the likes of LVMH, Burberry, Inditex (the owner of Zara), Estee Lauder and Switzerland’s Richemont. This sector could see further declines at the start of this week as the market assesses the long-term impact to sales and revenues.
Why the ECB may not be as dovish as some expect
The other main event that investors need to be aware of this week is the ECB meeting. It is the first major central bank to meet since the outbreak of war in Ukraine, and the markets will be hanging on the ECB’s every word at Thursday’s press conference. The invasion of Ukraine has dramatically altered the picture for central bank policy this year, and investors have rapidly re-priced Eurozone sovereign debt to take account of an expected dovish shift from the ECB in the coming days and weeks. However, on the other hand, inflation in the Eurozone is soaring and the ECB needs to stick to its price stability mandate. Inflation topped 5.8% last month in the currency bloc, and prices are likely to stay higher for longer after last week’s surge in commodity prices. At the end of last week Brent crude oil remained uncomfortably close to $120 per barrel, at just under $118 per barrel. Since we do not see prices across the broad commodity spectrum falling until a ceasefire is declared between Ukraine and Russia, then there is the potential for more upside for commodity prices, especially if central banks are too dovish on the back of geopolitical concerns that they cannot control. Thus, we expect the ECB to remain neutral, which could come across as hawkish to these jittery markets. A dovish ECB could see commodity markets surge and EUR/USD sink even further, it broke below the $1.10 mark on Friday and is at its lowest level since May 2020. A more hawkish Lagarde than expected on Thursday could see the euro recover, although we do view any recovery as temporary, especially vs. the USD, JPY and CHF. We continue to think that EUR/USD could decline back to the March 2020 lows at $1.07, especially if we get any more nuclear threats from Moscow or Kyiv falls in the coming days.
US inflation could embolden the Fed
Thursday will also see the release of US inflation data for February. After a strong labour market report at the end of last week, the Fed is under pressure to raise rates, and the market is now pricing in a 94.9% chance of a 25 bp rate hike from the Fed when it meets next week. We don’t think that the latest inflation reading will shift the dial on this expectation, especially as the market is expecting inflation to rise to 7.9% on an annual basis. There could be some “good” news in this report, as new and used car prices are expected to fall for the first time in 6 months. However, the fact that average hourly earnings in the US stalled in February, will mean that real wages (when adjusted for inflation) remain deep in negative territory, thus the Fed needs to hike rates to limit inflation and thus protect wages and consumers in the long run. Overall, we think that an inflation reading of 7.9% or above, is likely to keep the Fed in hawkish mode, the dollar strong, and stock markets even more jittery with only those stocks who have a strong balance sheet and a track record of making profits in difficult environments performing well in the medium-term.
Why bitcoin is no harbour in a storm
A quick word on bitcoin, there was talk last week that bitcoin and crypto in general had proved itself to be a safe haven in a crisis. However, day traders beware, bitcoin fell more than $5,000 at the end of last week, as traders’ price in the potential for a regulatory crackdown to avoid Russians using the crypto world to avoid global sanctions. Thus, bitcoin may not be the haven some expected it to be during this period of intense geopolitical crisis.