The first “R” is Russia. At various times in recent years, we have highlighted four broad themes that have impacted the market outlook: health, geopolitics, economic data and policy.
Of these, health and geopolitics can lead to extreme outcomes. We saw this over the last two years with the pandemic, and we have seen it at various times with geopolitics. For instance, under President Trump, geopolitical tensions triggered an escalating trade dispute between the US and China, and we are seeing it now with Russia and Ukraine.
When health and geopolitical issues come to the fore, they tend to dominate, superseding other influences and sometimes triggering significant market moves – as was evident in the first few months of the pandemic and also now following the Russian invasion of Ukraine. There is always an initial flight to quality – favouring sovereign debt – and a negative hit to equities as growth prospects are marked down, but markets often in such circumstances find it hard to price appropriately for risk.
Usually, no matter how significant they are at the time, health and geopolitical issues fade in terms of financial market importance, and markets once again become driven by the economic data and policy – but the key proviso here is that for the markets to see beyond the immediate risk, it needs to be possible to see the endgame and an improvement. In the early days of the pandemic, that endgame was not in sight and markets continued to move aggressively; the same is possible now.
In terms of the pandemic, it was the vaccination rollout that allowed markets to anticipate the return of economies to normal. Of course, with so many still unvaccinated globally, new variants are always possible. Also, there is the added uncertainty as to how China, the world’s second largest economy, handles its zero-Covid policy.
What then of Russia and Ukraine? Naturally, the loss of life is the biggest concern and the hardship being inflicted. What markets need to anticipate is the endgame and where things are left. The knee-jerk reaction of markets to the invasion reflects this difficulty.
Ukraine is a small open economy. After the military crisis of 2014, it suffered an economic and currency crisis, and then following IMF assistance it has embarked upon economic reforms, including addressing corruption.
I gave the keynote speech at the Ukrainian Financial Forum in Kyiv in 2019, and it was noteworthy then how the economy was reforming, with a range of key exports including metals, minerals, agricultural products, a shift into digital exports, and also that roughly two-thirds of its public debt was foreign owned.
Given its scale, the economic contagion from a hit to the Ukrainian economy will be limited – but it is already evident in one area, agriculture, with wheat prices rising. Yet it is the political and geopolitical risk from the invasion of a democratic sovereign nation that is huge.
Of relevance for the markets now is the impact of the crisis via Russia into higher energy prices, and increased future geopolitical tensions. An increased risk premium has been factored into energy prices, in case of supply disruptions. It is important to note, though, that this is not the only driver. Gas prices have been elevated for some time and oil prices were already heading higher before the crisis, as the global economy recovered and not helped by a lack of investment into fossil fuels, and also by rising inflation within that industry.
Higher energy prices may add to inflation concerns in western economies, but as they squeeze disposable incomes, they are often an early-warning sign of economic slowdown. Indeed that – plus the risk of where this war will lead – may dampen sentiment re post growth prospects in western economies. A worry is that this could become more drawn out.
There are many other issues currently being debated that we will not go into detail here, but it is important to note Western Europe’s dependency upon Russian gas and the inevitable imposition of tougher financial sanctions upon Russia.
The issue with any sanctions has, in the past, regardless of who they are against, been linked to openness and transparency and the need for actions to be targeted and not retrospective, thus avoiding unintended consequences. One would expect the same thoughtful, targeted measures now.
Also, it should be noted, Russian debt to GDP is low, around 17%, its foreign exchange reserves are high at $650 billion, over two-fifths of GDP, and its inflows from energy also significant, possibly $300 billion. It, too, has faced sanctions for some time now, although a ban on high-tech and other exports to it may have an impact.
In terms of the payments system, there is pressure to ban it from the Swift payments system for international transactions. However, Russia has created its own alternative payments system in recent years; and even ahead of this crisis there has been increased conjecture about future payments systems especially in a digital world. President Putin visited China recently; senior leaders from Iran and Pakistan have visited Russia. All this adds to the uncertainty of future payments and whether events could speed up such change in countries’ use of global payments.
The UK, too, like some other Western European countries are heavily dependent upon Swift for domestic as well as for international payments - the UK’s dependency given The City’s scale is high. This should not matter if the system proves resilient as one hopes it would be to possible cyber attacks; that presumably would be a greater risk were Russia to be excluded from it.
Also, at some stage there will be increased attention on the lessons of the conflict for other possible future geopolitical issues, such as Iran or Taiwan. Rising defence spending also may be one consequence, and the realisation that hard power may become of future greater relevance for financial markets.
The second ‘R’ is rates. Ahead of the invasion, it was the upward shift in interest rates that looked likely to be of most significance for markets this year. That may still be the case, despite the current geopolitical situation.
Central banks have been asleep at the wheel, misreading the inflation signals over the last year. Inflation has persisted, not passed-through quickly as they expected.
The challenge, noted before, is that if we move from a low to high inflation environment, the danger is that policymakers, like the markets, may be slow in anticipating the rise in inflation. There is little doubt that inflation expectations have risen significantly.
Let’s take the UK. At the start of the year, in The Times annual survey of economists only two, Charles Goodhart and myself, expected inflation to breach 7%. Now even the Bank of England is forecasting inflation will reach 7.5% by this spring, and to then remain elevated for some time.
At their recent policy meeting rates were hiked by 0.25% to 0.5% and four of the nine Monetary Policy Committee members voted to tighten by 0.5%. This is a big shift in their stance as Quantitative Easing (QE) was still being pursued up until the end of last year. This week, too, the Governor of the Bank of England spoke of inflation becoming “embedded” as opposed to “transitory”, his description a few months ago.
Central banks, though, need to be careful when they hike. Two wrongs do not make a right. Being wrong by easing through QE, when they should have been hiking last year, is not always corrected by aggressively tightening to make up for lost ground. If they misread the economy aggressive tightening may backfire – the second wrong. The rise in energy prices will likely add to possible growth concerns.
One of the big challenges for markets in coming months is how the economy (in the UK and globally) will react to policy tightening and where rates will settle.
Much depends upon how the global economy handles higher energy prices as well as monetary tightening – and how the UK economy (currently rebounding solidly) additionally handles the squeeze to disposable incomes from higher energy prices and imminent tax increases. Whereas the US is tightening monetary policy against the backdrop of a looser fiscal stance, the UK will be hiking just as fiscal policy is being tightened, too.
In all likelihood, current events in the Ukraine lessen the possibility of aggressive hikes. Also, a vital issue for markets is where rates may settle.
Even ahead of the pandemic, policy rates in the UK and elsewhere had settled at low levels. They were 0.75% before the pandemic. They then fell further.
For some time now, markets have accepted that the “neutral rate of interest” where policy rates can settle is very low.
The reason why neutral rates have been viewed as low over the last decade is because of weak domestic demand – the counterpart of which is high savings and low investment. It is part of the debate that has raged in the US over ‘secular stagnation’ (that private demand is too weak) and in turn has led to a reassessment of the role of fiscal policy – namely if inflation and neutral interest rates are low then this makes the case for greater use of fiscal policy, thus feeding into the modern monetary theory debate in the US, justifying higher budget deficits.
Such thinking has also led the IMF to claim over the last week that to curb inflation the UK should raise taxes – as opposed to hiking rates. I disagree with the latter. Also, if inflation rises then the debt dynamics change, as does the implication for interest rates.
I have previously called for a shift away from inflation to a nominal GDP target for the Bank of England, which would likely imply, say, that if inflation was 2% and growth 2% then policy rates should settle around 4%.
My issue has not been with rates being low, or that when they rise, they increase gradually, but that for some considerable time, when rates peak they do so at far too low a level.
For the moment, in response to recent signals from the US Federal Reserve and the Bank of England, markets assume tightening will be relatively fast over the next twelve months and that rates will settle at still relatively low levels: that is still sharply higher than current neutral rates of close to zero but, in the case of the UK, perhaps less than half-way towards where rates may need to be if they were to be in line with nominal GDP.
Even if one was to focus solely on inflation, never mind nominal GDP, UK policy rates are expected by the market to peak at below where inflation may be in 2023. The market expects base rates to peak below 2% by the middle of next year, while inflation may be around 3% then. If rates are less than inflation, then “real” interest rates are negative. This is hardly indicative of a tough monetary policy.
The risk in curbing inflation is that interest rates may need to go higher, but if that is the case then economic growth may be hit hard.
Of course, UK growth may slow this year, particularly as discretionary spending is squeezed. That in itself, may limit the Bank’s ability to tighten as this year progresses. Too low a level of policy rates creates additional challenges, adding to rampant asset price inflation; and also meaning markets are not pricing fully for risk.
The third “R” appears of far less significance now but should still be noted and that is Rotation.
This refers to the pricing that was built into equity markets at the start of the year and relates to a movement away from growth (tech stocks in particular) towards value stocks. This was not the first time that rotation has been used to describe equity market moves: last year, too, it was used, ex post, to describe what had occurred, rather than ex ante to predict what was imminent.
This year it captured wider concerns about the economic outlook, once the post-pandemic rebound wears off. At the time, while the impact on equities was significant, the UK FTSE 100 held up better than other major indices.
In conclusion, the risk of contagion from the Russian invasion of a Ukraine is the dominant influence on markets. This geopolitical issue looks set to dominate for some time until there is greater clarity about the endgame.
Until then markets will need to factor in the greater geopolitical risks that now prevail. And if these grow then it may not prevent interest rates rising but limit the pace and scale of near-term tightening.
Markets do not like uncertainty but with Russia and rates that is what they have.
Please note, the value of your investments can go down as well as up.
