Monday digest

Posted 28 February 2022

Last week’s invasion of Ukraine by Russian forces invoked memories (for some of us) of the cold war era of the 1980s. Over the last few days, as Russia launched missile strikes against buildings in Kyiv, Kharkiv and other major Ukraine cities, and Ukraine citizens were forced to flee from their homes or arm themselves for conflict, it has felt as momentous a moment in history as any felt in Europe since the second world war. It was even more remarkable, therefore, that at the end of last week global investment markets, with the notable exception of Russia’s stock market, had rallied back to roughly where they stood one week previously. History reminds us that armed conflicts rarely foreshadow particularly destructive episodes of capital market performance. This year, markets have already been under considerable pressure as pandemic-prompted governmental and central bank policy support is wound down. Investors have possibly reacted less negatively to the unfolding situation in Ukraine than one would anticipate because they calculate the external shock of this geopolitical event may slow down or even reverse the withdrawal of policy support for a while longer.

The cost of energy in 2022, and possibly beyond, could depend on the level of sanctions imposed on Russia. Putin’s strategy of constraining supply during this winter, thereby creating a cost-of-living crisis, appears to have worked well for him. Current sanctions do not extend to Russian energy giant Gazprom and, perhaps unsurprisingly, gas imports from Russia though Ukraine’s pipelines were up last week. In this context, economists talk about ‘moral hazard’, the need for our economic and financial systems to impose costs on people that behave immorally. Unfortunately, those costs are borne not just by the instigators – but felt by individuals and companies as well. It may feel incongruous, but share prices could move higher should the West choose not to impose sanctions too heavily.

The relationship psychodrama that has been playing out between a Putin-led relatively isolated Russia and with much of the rest of the world has been a major step back in terms of global political cooperation. However, the limited immediate options for retaliation by the West (because of its gas dependency on Russia) mean events could quite possibly at first lead to more positive policy measures for the global economy. This is because the only way to penalise Russia for its actions, prevent it from further territorial expansion and deprive it of the necessary funding, is to significantly increase military and alternative energy supply funding in western Europe. This could indeed serve as a stimulus for Europe’s economy, and restrict the Ukraine crisis to a regional conflict unlikely to reverse the global economic upswing taking place.

Bond market inferences

Before the current tensions, yields were climbing steadily this the year – pushed up by the prospect of a sharp tightening of monetary policy. But now we are seeing a stabilisation of this trend, with yields coming down from the peak reached two weeks ago. However, given the negative scope of geopolitical events, government bond moves have nevertheless been relatively muted. Below the surface, we can see a few intriguing developments. Expectations for central bank tightening, especially in Europe, have been pared back, even while inflation expectations have continued to rise. In other words, markets are treating the upcoming rise in inflation through higher commodity prices as a ‘cost shock’ lowering growth, and therefore less likely to result in lasting structural inflation. Widening credit spreads point in the same direction. At the same time, we take some comfort that liquidity in government bond markets has been good, and the absolute change in yield levels and expectations has stayed within past trading volatility ranges. This is markedly more stable and positive than the market reaction to spreading Covid uncertainty two years ago.

As well as interest rates, bond markets have also shifted their inflation expectations. Inflation-linked government bond yields have fallen faster than fixed income debt, meaning the difference between real (inflation-adjusted) yields and nominal yields has widened. This suggests a pick-up in inflation expectations, likely from the spike in oil prices and the fallout from Russian sanctions.

The Ukraine crisis has brought huge volatility across most regions and assets – bond markets included. But despite large price moves, we have not seen signs of trading liquidity stress. Bonds are still being actively traded and in large volumes, meaning enough cash is flowing to make the global financial system tick. That is a positive sign at least, since liquidity stress is the hallmark of financial crises. Moreover, even though bonds have been volatile, the current phase has not seen a big spike in measures of volatility. These had already risen since the start of the year, as markets braced for a much more hawkish Fed policy. Central bankers will, no doubt, be worried about the current market correction, but will be pleased investors are not scrambling for cash. That is what we saw in the sharp pandemic sell-off of March 2020, as risk aversion reached fever pitch and markets went into meltdown. Avoiding any repeat will be the priority for central bankers – meaning calmer messaging is likely.

Flash PMIs suggest a more promising path
Amid the concern regarding Ukraine, investors might have missed some positive economic data last week that would normally have been front and centre of market news. Business sentiment according the the latest ‘Flash’ Purchasing Managers Indices (PMIs) improved substantially during February. The US manufacturing sector PMI registered a two-month high of 57.5, while the PMI score for the services sector came in at 56.7 – also a two-month high (a score above 50 indicates economic expansion). PMIs, are a reliable indicator of near-term economic growth as they are so closely tied to capital expenditure decisions such as whether to build new plants or simply stock higher inventories. Such decisions have a big impact on wider economic growth, and firms are more likely to invest when they feel confident. On the other side, service businesses make investment decisions around technology and labour – and are more likely to hire and invest into their cost base when their outlook is strong. For that reason, services PMIs are more closely related to consumer sentiment, routinely used as a proxy measure. As the world recovers from the pandemic, the ebbs and flows of consumer sentiment will have a huge impact on the economy, making service sector PMI a crucial investment indicator.

An uptick in PMIs is therefore a welcome sign. Growth slowed sharply toward the end of last year, as the spread of Omicron, tighter central bank policy and a looming shock to disposable incomes from skyrocketing household energy costs weighed down on the economy. But this wave of the virus slowed into the beginning of the year, and case rates and hospitalisations continue to fall across the UK, US and Europe. JPMorgan’s mobility data shows a normalisation in all those regions, which should lead to. Rebounding PMIs provide solid evidence a wider economic recovery is now happening.

Oil prices add a sour note to this sweet story. Fuel prices have been a huge component of the rise of input costs, affecting businesses and consumers at every stage of the chain. Brent crude oil is now at its highest price since 2014 (just over $98 per barrel at the time of writing) and geopolitical tensions mean it could go higher. That said, other inflation pressures seem to be abating. Supply chain problems have cleared up this year, according to the Fed. This backs up recent reports that supply bottlenecks are easing. Should this trend continue, it would lead to a slowdown in inflation – even if oil prices continue to rise. This is unlikely to mean falling or even stationary prices, but it should mean an end to the rapid inflation we saw last year.

Businesses may expect consumers to be more confident, but the cost-of-living crisis has had a big impact on sentiment, which will be worsened by a continued spike in oil prices. We should, therefore, be cautious before calling this the turnaround point. At the very least though, a pick-up in business confidence should improve the jobs market, which will ease the cost pressures facing consumers. However, for growth to continue at a decent pace – and inflation to come down from dangerous levels – a big section of those who left the labour market in last year’s ‘great resignation’ will need to return. Dwindling savings rates and the return of reliable childcare availability could prompt this, but it is not guaranteed. If they do, it will help contain labour costs and bring down fears that supply side price rises will turn into lasting, structural inflation.

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