Equities drop as oil prices spike

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

What happened?

Equity markets fell on Monday, with the S&P 500 closing down 2.95%. European markets had earlier closed the day 0.9% lower, while in Asia the Hang Seng Index closed down 3.8% and the Nikkei 225 2.9%. Moves in fixed income and currency markets were more muted, with 10-year Treasury yields up 1 basis point to 1.74% and EURUSD down 0.2% to 1.09.

The primary catalyst for the weakness in equity markets was a further increase in commodity prices. Oil prices ended the day up 5.6%, with Brent crude trading at USD 124 per barrel, having briefly hit USD 139 in Asia trading early Monday. European natural gas prices rose as high as EUR 345 per megawatt hour before falling back to EUR 214. For comparison, 12 months ago they traded at EUR 16/MWh

US Secretary of State Anthony Blinken suggested over the weekend that the US is considering banning imports of Russian oil, though European leaders have voiced a more gradualist approach. On Monday, German Chancellor Olaf Scholz stated that the “German government has been working hard…to develop alternatives to Russian energy. However, this cannot be done overnight,” and UK Prime Minister Boris Johnson said the UK “can’t turn off Russian gas overnight.”

Elsewhere, in a sign of a potential softening in the Kremlin’s posture, spokesman Dmitry Peskov stated in an interview with Reuters that Ukraine should “recognize that Crimea is Russian territory and that they need to recognize that Donetsk and Lugansk are independent states. And that’s it. It will stop in a moment." He added that Moscow was not pursuing any further territorial claims, nor a handover of Kyiv.

How do we interpret this?

In our?CIO Alert?“Downgrade equities to neutral” on Friday, we highlighted that in our central scenario we would expect any energy sanctions to contribute to the?gradual?removal of Russia from global energy supply chains, rather than forcing an immediate halt to energy flows. In this scenario, we would expect Brent crude oil prices to hit USD 125/bbl in June but fall back to USD 115/bbl in September and USD 105/bbl in December. A few months of elevated commodity prices would likely hurt growth and corporate earnings, but in this scenario we would still expect earnings growth to remain positive overall for 2022.

However, the weekend statements from Secretary Blinken opened the possibility of a more sudden halt, even if various European states have voiced opposition. In our downside scenario, oil prices could rise above USD 150/bbl and gas could need to be rationed in Europe. Should these conditions materialize, we would expect a significant negative impact on economic growth and corporate earnings in Europe, stretching into 2023.

How to invest?

Amid continued uncertainty about Russian President Vladimir Putin’s intentions, the extent of future sanctions, military outcomes, the defense policies of non-NATO states, China’s perceived posture, commodity prices, global growth, inflation, and central bank policy, we believe it is currently hard for investors to attach high confidence in any individual market outcome materializing, and we hold a neutral stance on equities.

But we also note that historically, geopolitical events—even those that have changed the course of history—have rarely left a long-lasting mark on markets.?We recommend several strategies for positioning in the current environment:

1. Build up portfolio hedges.?Amid the risk of further equity market volatility driven by commodity supply disruptions, we think broad commodities remain an effective portfolio hedge in the current environment. Energy equities, still a preferred sector, are also likely to benefit in the event of further increases in commodity prices. We also see the global healthcare sector, the use of dynamic asset allocation strategies, and structured solutions as potential means of reducing portfolio volatility. In the short term, we also believe the US dollar can act as an effective portfolio hedge.

2. Position for the energy transition.?The recent jump in commodity prices, including a spike in Brent crude to its highest level since 2008, poses risks to growth and earnings. However, a period of high commodity prices also looks likely to increase focus on energy security and independence. In conjunction with a desire to reduce carbon emissions, we believe this is likely to favor investment in greentech, and clean air and carbon reduction solutions.

3. Prepare for rising rates.?Higher commodity prices are also likely to mean that inflation will stay even higher for even longer. Although current financial market volatility means the potential pace of interest rate increases is uncertain, high inflation means we are likely to see higher interest rates this year. In equity markets, the financial sector typically benefits from rising rates, and value sectors generally outperform growth sectors as rates rise. In fixed income, investors can consider US senior loans, which offer an attractive yield and a floating-rate structure.

4. Seek opportunity in China. We like Chinese equities relative to other markets in Asia and see the market as well positioned for the current environment. After underperforming last year, China is attractively valued, is likely to see accelerating growth through the balance of 2022, and should be boosted by loosening fiscal and monetary policy. Chinese equities are also relatively well insulated from some of the key global market risks, including inflation and the Russia-Ukraine war.

5. Find long-term value in stocks.?Given the magnitude of uncertainty, further declines in stocks are possible. Our S&P 500 target in our downside scenario is 3,700. But the recent market sell-off means there are now many stocks and sectors trading well below recent highs, creating a potentially attractive entry point for long-term investors. We expect strong secular growth for companies exposed to artificial intelligence, big data, and cybersecurity―the ABCs of tech.?We also like select names driving the 5G upgrade cycle. 5G is expected to be commercialized over the next three years and will impact a wide range of industries. We expect the 5G market to grow by more than 9x from 2022 to 2025, with total 5G equipment revenues reaching USD 150bn by 2025.

6. Diversify with alternatives.?The war in Ukraine, combined with concerns about inflation, is driving much higher portfolio volatility. This makes diversification across different regions, sectors, and asset classes more important. Hedge funds can help diversify portfolios beyond stocks and bonds and may help reduce overall portfolio volatility. Certain hedge fund strategies are specifically designed to outperform during periods of volatile or falling markets.

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