Russia’s invasion of Ukraine shook up the world. It’s the largest war in Europe since 1945. The human suffering is enormous, and our thoughts are with the people of Ukraine.
The repercussions will be long lasting as the world rethinks its relationship with Russia. The ripple effects from the severe sanctions on Russia will have further consequences for the global economy, markets, and inflation. Russia is one of the world’s leading energy- and commodity-producing countries, while Ukraine is a major player in agriculture products.
From an economic standpoint, European growth rates are expected to be downgraded significantly as consumer confidence wanes and given its greater dependence on Russian energy. The European Union is estimated to be the largest importer of natural gas in the world, with the most significant share of gas (~40%) coming from Russia. Likewise, higher energy and agriculture product costs will likely disproportionately impact segments of the emerging markets, given lower consumer incomes; Asian countries are also largely a net importer of energy.
Although the U.S. economy is not immune to these events given the interconnectedness of the global economy and given that higher oil prices will hit U.S. consumers, the domestic economy is more insulated than other developed economies. Importantly, unlike 30 or 40 years ago, the U.S. is now a significant energy producer. Moreover, the improvement in COVID-19 trends is underappreciated in the sea of gloom. Our expectation is that consumer demand for services, including travel, will remain robust this year as the pandemic becomes endemic. Our macro team expects U.S. growth to move a notch lower, but still see near-term recession risks as relatively low.
From a market perspective, the range of outcomes has widened. However, our base case outlook remains that what we are seeing in the U.S. markets is a correction within an ongoing bull market. While this is the first double-digit correction since the pandemic, it is important to remember that the average maximum drawdown for any given year for the S&P 500 is 14%. Thus, while this correction has been deep, it is not abnormal by historical standards. This is the admission price to being in the market. Importantly, our work shows that while geopolitical events often cause a short-term market dip and choppy waters, unless they push the U.S. into recession, markets tend to rebound over the next 6-12 months.
Notably, the entire market correction this year has been driven by fear and a subsequent contraction in valuations. Forward earnings estimates for the S&P 500 continue to move higher. Given how well corporate America adjusted during the pandemic—where profits snapped back faster than most anyone anticipated—we would not underestimate the ability for companies to once again adapt and adjust.
Therefore, we maintain our long-standing equity overweight to the U.S., which we view as the big, blue-chip country with higher-quality companies. Given expected downgrades in European growth and weakening relative price trends, we stay underweight the international developed markets. Likewise, with heightened global risk and our continued concerns about the regulatory environment in China, we retain an unfavorable view towards emerging markets.
Within our sector strategy, we recently downgraded financials to neutral after strong relative performance this year, given that geopolitical tensions likely put a cap on longer-term interest rates and will have some impact on global growth. Conversely, we upgraded consumer staples to overweight and utilities to neutral given our expectation for continued choppy waters near term.
On the fixed income side, we remain underweight bonds, though as we discussed last month, the rise in yields has incrementally improved the outlook. Our fixed income team’s view is that the market had become too aggressive with pricing in six or seven Federal Reserve (Fed) rate hikes. While many investors started to question the value of bonds as a diversifier given stocks and bonds are both down this year—recent days have shown strong buying demand for U.S. Treasuries. This serves to reinforce that high-quality bonds still play an important portfolio role. Also, given wider outcomes for the financial markets, we are moving our house view to a neutral bond duration from below-benchmark.
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