Markets Weekly podcast – 28 February 2022

Henk Potts (HP): Hello. It’s Monday, 28^th February and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider the broader economic and investment implications arising from the conflict in Ukraine. And finally, I’ll conclude by previewing the major events and data releases that are likely to shape the week ahead.

Russia’s decision to launch a full-scale invasion of Ukraine sent a shockwave through global financial markets last week. Markets’ initial reaction was to predictably rush into safe-haven assets, developed government bonds rallied, 10-year Treasury yields fell to 1.86%. Money flowed into the dollar, the Japanese yen, and, of course, the Swiss franc. Gold hit $1,942 an ounce, that’s its highest level since September 2020.

Of course, energy markets surged. European gas prices jumped more than 40%. Crude rose above the $100 a barrel mark for the first time since 2014. And global equity markets sold off, with many of the major indices falling into correction territory. European equity markets were off round about 5% on the first day of the attack. Russia’s MOEX index slumped 33%, which was the fifth largest single-day slump for a benchmark index.

However, as the week went on, you could argue markets did regain some of their composure. Western allies unveiled a measured package of sanctions. We’ll come on to those in a little bit more detail, and how they’ve changed over the course of the weekend. And Russia said it was willing to hold talks with Kyiv. However, there’s been no indication that the government of Ukraine is willing to negotiate, nor any signs of a cessation in the fighting.

So, while the intraday movements were dramatic, the net-net weekly performance in many of the key markets was actually relatively subdued, as investors speculated that the added uncertainty may dissuade central bankers from aggressively hiking rates in the coming months, and dip buyers tried to take advantage of lower prices on the screen.

European stocks jumped 3.3% on Friday. That’s the biggest single-day gain we’ve seen since November 2020, although the STOXX 600 index was down 1.6% over the week, and is 8.5% below its 52-week high on 4^th January of this year.

Over on Wall Street, US equity markets staged an impressive turnaround on Thursday, and added to those gains on Friday. This is as investors were attracted to US stocks given the relative security of large US tech names. The S&P 500 was actually up four-tenths of 1% over the course of the week, although still down 3.3% for the month.

In terms of bond markets, the 10-year Treasury yield ended the week back close to 2%, near the highs that it hit earlier this month, as the surge in commodity prices created additional upside risk to near-term inflation. Two-year yields jumped last week, and the gap between the 2- and 10-year yield narrowed to 40 basis points, compared to 46 basis points in the prior week.

From a macro perspective, the Russian/Ukraine conflict could have a multi-channel impact in areas including energy, policy, trade, and banking. The main channel of impact for the European economy from the conflict comes from the energy market. Remember, Europe imports about 40% of its gas from Russia. Germany’s actually even higher than that, somewhere close to 50%, and about 25% of its imports of petroleum oil products.

Ukrainian pipelines are the second most important route, accounting for around one-third of Russian flows into Europe, so there are valid concerns about how much gas Russia will send through the Ukrainian pipeline and any potential damage to the infrastructure. It’s also worth remembering Russia exported about five million barrels of oil per day in 2020, almost half of that went to Europe, that’s according to the US Energy Information Administration.

The worst case scenario, I suppose, is one in which Russian exports are significantly curtailed. That could look very similar, I suppose, to the 1990 Gulf War that led to roughly four million barrels of oil per day supply disruption. We should note sanctions have not yet encompassed energy exports, but there is a real risk that this could become part of the strategy from the West.

Higher oil prices, and, of course, potential rationing, could weigh on industrial production, corporate profitability, and households’ real income, which, in turn, would have a negative impact, of course, on real GDP. That said, the size of the impact would differ across different countries, and would also depend on fiscal measures governments might take to limit the pass through of this additional energy shock on consumers and firms.

In terms of the policy impact, higher energy prices add further complexity to the balancing act being performed by central bankers. Supply shock, of course, could add to the already stretched energy market, pushing up prices and overall inflation further, and, therefore, adding to that the risk of secondary effects on areas such as wages. However, higher energy prices would also likely increase the trade shock and downside risk to growth. We think that central banks have enough optionality to try and react to some of those downside risks.

In the trade channel, the risks look largely contained to the Baltics. Russia and Ukraine, remember, represent only a small export market for a majority of euro-area member states, while many of these countries import a larger share of goods from Russia and Ukraine than they export to.

In terms of the financial channel, the escalation could impact the European Union’s banks directly via their exposures to Russia. Austrian, French, and Italian banks, you could argue, are the most exposed. If you look at the data coming through from the Bank for International Settlements, Austrian banks’ exposure to Russia is sizeable, around 4.6% of Austrian GDP. For Italy and France, it’s significantly lower than that. But we should remember, of course, that banks are much better capitalised after the great financial crisis. The risk of a systemic impact on the financial system has been dramatically reduced.

So, to discuss and evaluate the potential impact of the conflict on the global economy and financial markets, I’m pleased to be joined today by Julien Lafargue. He’s Chief Market Strategist with Barclays Private Bank.

Julien, great to have you with us today. So when you look at the ramification of Russia’s attack on Ukraine, where do you see those major stress points, and does that change your view of the macro backdrop?

Julien Lafargue (JL): Well, as you rightly pointed out, the implication varies depending on which region you’re looking at, and the closer you get to the epicentre of this crisis, the more damage you’re going to see and the more downside you’re going to see. So, Russia is most likely going to enter into a deep recession in the coming months, following European and US sanctions that have been announced over the weekend.

The whole region close by to Russia, Germany in Europe, are because of their higher reliance on energy coming from the country, might be more exposed, and as you move away from the region, and you go to the US, you could argue that probably the implications are much more muted. Some companies with ties to Russia may be impacted, but broadly speaking, if you’re thinking about equity markets in particular, the ultimate impact should be relatively small.

What’s going to happen in the back of this crisis is a big question mark, and there are various channels, as you mentioned, through which we could see this crisis spill over. Energy is a big one, and I think in investors’ minds the key question here is, what’s next for central banks? They were the issues, so to speak, prior to this crisis, but they’re still there, and this is what we believe is going to be the key driver of markets for the next few months, rather than the crisis.

We will see heightened volatility as headlines come across around from the sanctions, an escalation of the conflict or, indeed, escalation, but what the market wants to hear is what are central banks going to do about it. And, as you said, they have some leeway they’ve been able to build over the past few months, trying to give them the optionality as to whether it makes sense or not to hike rates, or wait and see.

Definitely, these prices will have an impact on global growth. It’s hard to quantify. Some analysts have tried, but because of the different channels into which this crisis could percolate throughout the global economy, it’s hard to put a number on it. But clearly, there is downside risk to growth.

Now, is this downside sufficient enough for central banks to decide that hiking interest rates is the wrong move, or will they look at the other side of the coin, which is to say that energy prices are probably going higher, or at least being sustained at elevated levels, which means that inflationary pressure could continue to remain quite elevated for the foreseeable future, and, therefore, it makes sense to try and cool down the economy even further to reduce those inflationary pressures.

In our mind, banks probably don’t want to kill this optionality, and, therefore, they might want to go ahead and still maintain some hawkishness. But, clearly, some of the expectations that were built in the market, up until Russia decided to invade Ukraine, those were way too hawkish, and we’re probably going to see those being pulled back a bit, with less rate hikes being priced in, and probably a Fed, as well as other major central banks, trying to take some time and see how the situation unfolds before making any harsh move.

HP: As we’ve been discussing, it’s clearly a volatile time for global equity markets. Do you see further downside risk, particularly, of course, if those sanctions become more severe?

JL: The same way it’s very difficult to forecast what could be the ultimate impact on global growth, because it’s early days and sanctions are still being decided as we speak, and implemented. It’s difficult to see how much more downside you could see, and the range of possible outcomes is so significant that even assigning probability to each of those is, in our mind at least, a bit of a futile exercise.

There are two things that will come to the rescue of markets on the downside. One is valuation. At some point everything has a price, and at some point markets will get cheap enough that people will be looking to look past the short-term uncertainty, and try and benefit from cheaper valuations.

We’ve seen multiples compress since the beginning of the year, and really since last year. That wasn’t driven by Russia, it was driven simply by expectations that central policy will be less accommodative. So, we have already built a bit of a buffer from a valuation perspective. There’s probably another one, maybe two points of multiple, that could be removed from the market on further escalation, but we think that we’re getting closer to a level where markets, equity markets in particular, start looking attractive over the medium term.

The other support will come from central banks, and whether or not they confirm this intuition that we have that they will be willing to proceed with caution when it comes to normalising those policy rates. We will need to wait a couple more weeks to hear officially from the ECB and from the Fed as to how much they’re willing to take out of the current very hawkish bias that they’ve expressed, but we think that this could be the second buffer that investors will find in their way on the downside.

If we were to put numbers around that, is it 5%, is it 10%, is it 15%? Again, very difficult to say at this stage, but we do believe that a lot has been priced in, and unless you see a very meaningful escalation, that being whether European countries start imposing sanctions on energy itself, or energy flows, or if you see Nato starting to be more involved from a military perspective, unless you see that, we think that the downside from here should be relatively limited.

HP: So if the downside is limited, the next obvious question is, I suppose, is this an attractive entry point for equity market investors?

JL: Well, it might not feel that way, given all the uncertainty that we have to deal with at the moment. Now, if we look historically, those types of conflict, no two conflicts are exactly the same, but those type of conflicts happen, and historically markets have been able to reach all-time highs, and not so long ago we were making new all-time highs. So, like any other crisis, hopefully, this one shall pass too.

It’s very difficult to say is today the low point, is it going to be on Wednesday, is it going to be next week, next month? What we can see, and what we can say, is that although there is some downside risk to growth, it’s not like the world is about to enter a massive recession, at least that’s not our view.

Some companies may see significant earnings downgrade, but, as a whole, markets shouldn’t. We will see some pressure on earnings, but not anything that should prevent global companies to deliver another year of earnings growth this year and next year.

So with that in mind, is today the best entry point possible? That’s impossible to say. Is today a good entry point? We think so. And for investors who might be a bit reluctant to invest, it certainly hasn’t been the best strategy. The best strategy is always to be 100% invested all the time, but at least considering stepping in and averaging into this market might feel a bit more comfortable, but also might help over the long term. So, in our opinion, starting today is not a bad option.

HP: Julien, we know one of the most important attributes a good investor has is the ability to maintain composure during times of stress. Can you contextualise that concept for us, given some of the disturbing developments in Ukraine over the course of the past week?

JL: Sure. Well, if you look at historical performance, we always say that they should be relied upon, but that’s the best thing we have to imagine what could happen next. And if you look at how, especially on the stock markets, how performance has been delivered over time, it’s fairly easy to see that the longer you stay invested, the lower your chances are to have a negative experience. That means that if you’re invested for a month, really your entry point is critical for the possible outcome, and you should really care about investing today or tomorrow, trying to time the bottom if your investment horizon is that short.

Now, if you extend this investment timeline, and you stay invested for a couple of years, five years, 10 years, then that drastically reduces the likelihood of you as an investor experiencing negative return. And so being able to take away the noise, and there is a lot of noise these days, being able to take away that noise and focus on those long-term goals, like what is this investment meant to be over the long term, is critical. And by maintaining composure, ie by staying invested, you’re actually reducing the risk of those goals not being met over time.

The wrong move in those type of events is to say, I’m going to sell everything and wait for clarity to happen. This is the wrong move for two reasons. One, because clarity is never totally there, and if it’s totally there, it means that the market will have recovered and you will be left on the side line. And the second is, by doing so you’re implying that you can find a better entry point, and the reality is, we’re only going to get, as we were discussing earlier, we’re only going to get a better entry point from here if the situation worsens. And if it does, it’s going to be even more difficult for anybody to commit capital in that situation. So, staying invested is probably the best move that people can do, especially if they have a medium- to long-term investment horizon.

HP: Well, thank you, Julien, for your insights today. We know the situation in Ukraine is clearly a fast moving one, and we will, of course, continue to monitor developments closely and analyse the impact for investors.

The week ahead, of course, will continue to be dominated by the geopolitical picture, but on the data front the markets will have to wait until Friday for the big number of the week, when we get the nonfarm payroll report. January’s print, remember, exceeded all expectations, showed hiring in the United States remained robust, despite disruption being caused by Omicron. We look for that momentum to have continued last month, we think the US economy created 450,000 jobs in February. We look for the unemployment rate to ease back down to a post-pandemic low of 3.9%, helped by an improvement in the participation rate. We expect average hourly earnings to rise by half of 1% month on month.

And with that, I’d like to thank you once again for joining us. We will, of course, be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.