CIO Alert: Ukraine crisis: Market scenarios from here

Originally published as a CIO Alert by Mark Haefele, Chief Investment Officer for UBS Global Wealth Management

What happened?

The crisis in Ukraine is evolving rapidly. Russian President Vladimir Putin recognized the two separatist republics in eastern Ukraine. Western nations condemned his actions and imposed sanctions: Germany paused the approval of the Nord Stream 2 gas pipeline, and the UK imposed sanctions on three individuals and five banks. US President Joe Biden described Russia’s actions as the beginning of an “invasion,” and announced sanctions against two Russian financial institutions, Russian sovereign debt, and a number of individuals in Putin's inner circle, as well as threatening more in the event of a further escalation in the crisis.

After initial losses—the Stoxx Europe 600 dropped as much as 1.9% in early trade—European equities closed little changed on Tuesday. The S&P 500 closed 1% weaker and the Nasdaq 1.2% lower, after being closed for a US public holiday on Monday.

Ten-year US Treasury yields dropped as low as 1.85% in European hours, before finishing also little changed at 1.93%. Brent crude oil reached USD 99.5/bbl intraday, its highest level since September 2014, but finished up 1% at USD 96.33/bbl. The US dollar gained 0.1% against the euro.

How do we interpret this?

The equity market recovered from its lows during European hours after Putin said he wanted to continue to supply Europe with oil and gas, which tacitly implied that he is happy to have Europe provide the continued funding for Russia’s troops in Belarus and Eastern Ukraine. Europe’s announced sanctions being less severe than feared tacitly indicated that they don’t want to risk disrupting the energy supply from Russia, and therefore effectively will continue to fund Russia’s military actions. The markets later bounced off their lows in US trading after Biden announced only moderate sanctions, and recognized he intends to minimize any impact that sanctions could have on the US economy.

The extent of sanctions announced and threatened will, in our view, be insufficient to deter Putin from further incursions in the Donbas region, nor the possibility of limited strikes in other areas of Ukraine or cyberattacks to destabilize the country. Our base case is that Russia seeks to consolidate control of the Donetsk and Luhansk regions, including deploying troops into areas not currently under the control of pro-Russia separatists. Russia may also send troops further into Ukraine in an attempt to destabilize the Ukrainian government. Should this occur, the West’s response would likely escalate to include limitations on international payments or on critical imports like semiconductors.

In our view, the limiting factor on Putin will not be Western sanctions but his own assessment of the costs of a wider campaign in terms of resources, Ukrainian resistance, and political support at home in the event of wider conflict. Ultimately, we also think that Putin has a strong interest in continuing to sell energy and other commodities to Europe, which speaks against a long-lasting military engagement. The risk case is that the crisis remains a source of continued volatility for an extended period until a new point of stalemate is reached.

In the extreme risk case, which we would define as one that has a lasting and material negative impact on global growth, the conflict escalates to a level that pushes Western nations to accept disruption to Russia's energy flow. If oil prices were to rise to USD 125/bbl or higher for two quarters, it would result in roughly half a percentage point lower in global GDP growth, and higher inflation affecting consumer spending power. Should Russia’s energy flow be disrupted, higher risk premiums and lower global earnings estimates would likely trigger more long-lasting losses for equity markets.

What investors should do

The situation is very fluid and highly uncertain, so we don’t think this is a time to attach high probabilities to any individual scenarios. But at the same time, we note that historically, the greatest risk for investors from geopolitical crises has come from overreacting and under-diversifying. While it is impossible to judge the precise timing and magnitude of geopolitical effects on markets, such events have generally not prevented equities from moving higher over a medium-term horizon, and drawdowns driven by geopolitical stress events are typically short-lived for well-diversified portfolios.

We think it is important for investors to maintain a calm stance and keep a broad perspective, which would help build a portfolio robust enough to survive the Ukraine crisis and rising US interest rates, as well as the fact that global growth remains above trend and market sentiment is already weak.

We see five key action points that can keep portfolios on track amid the uncertainty:

1. Keep a diversified portfolio.?By diversifying across regions, sectors, and asset classes, investors can reduce their exposure to idiosyncratic risks related to the crisis in Ukraine, or to other potential emergent political risks around the world. The combined revenue exposure of the S&P 500 to Russia and Ukraine, for example, is only about 1%. Diversification offers intrinsic bear market protection; in bear markets since 1945, the S&P 500 fell an average 34.5% and spent 39 months (about three-and-a-half years) “underwater,” while a 60/40 portfolio lost an average of 20% and registered a fresh record high, on average, within 30 months (about two-and-a-half years).
2. Use commodities as a geopolitical hedge.?Russia accounts for around 40% of the European Union’s gas imports, and 30% of its oil imports, and is also the world’s largest wheat supplier. Meanwhile, Ukraine is a material exporter of corn, wheat, and oilseeds. Amid the risk of supply disruptions, we think broad commodities can be an effective “geopolitical hedge” for portfolios, as well as offering an attractive source of returns in an environment of accelerating growth, persistent inflation, and higher rates. That said, we keep a negative view on gold and silver, which we think are likely to face downward price pressure amid higher US interest rates and a stronger USD.
3. Position for US dollar strength.?The US dollar is a “safe-haven” currency that tends to rally in case of heightened geopolitical uncertainty or “risk-off” sentiment in financial markets. In addition, we think that expectations of six or seven US interest rate hikes are likely to support the US dollar in the months ahead. As such, we see the US dollar as an attractive tactical currency position at present.
4. Buy the winners from global growth?Against a backdrop of heightened concerns about Ukraine, inflation, and interest rates, it is important to remember that global economic growth is accelerating as COVID-related restrictions are lifted. We think this should continue to favor value and cyclical sectors and markets, including energy, financials, and the Eurozone. It is worth noting that, despite their proximity to the crisis in Ukraine, the continued outperformance of Eurozone equities compared to US equities over the past month shows that the forces of economic recovery remain powerful and are potentially still a more important driver of global markets than events in Eastern Europe.
5. Build up some defense.?With uncertainty potentially set to remain elevated, investors looking to reduce volatility in portfolios can consider balancing some of their cyclical exposures with defensive sectors and strategies. Global healthcare is still our preferred defensive sector, and we also see dividend strategies, dynamic allocation strategies, and the use of structured solutions as potentially attractive means of improving the risk-return profiles of overall portfolios.

Ubs.com/cio-disclaimer