Escalating Warfare and Sanctions: What Investors Need to Know

As the humanitarian crisis in Ukraine resulting from Russia’s invasion and subsequent warfare continues to reach dishearteningly tragic levels, sanctions imposed by the U.S. and Western allies have increased in number and magnitude. 

Up until recent days, sanctions on Russia had almost entirely focused on the global financial system.  These included the removal of Russian banks from the Society for Worldwide Interbank Financial Telecommunications (SWIFT), a prohibition on conducting business with Russia’s central bank, and an asset freeze on Russian reserves held outside the country.

However, sanctions entered new territory on March 7 when President Biden announced a U.S. ban on the purchase of Russian oil, signifying a definitive escalation beyond just the financial realm. In 2021, Russia exported approximately 250 million barrels of oil into the U.S., representing about 8% of American imported oil and 10% of Russia’s energy-based exports.

Taking into account this newly established backdrop, we believe important points for investors to recognize include:

The move to restrict Russian oil from U.S. markets is likely to prove more inflationary. The ban on Russian oil will almost certainly exacerbate inflation, which has already reached highs not seen in more than 40 years, in the U.S. and globally. We also see oil prices such as West Texas Intermediate Crude and Brent Crude continuing to reach highs in the months ahead.

It is not yet known if Europe will follow the U.S. lead on banning Russian oil exports. While the U.S. relies on Russia for only about 10% of its oil imports, Europe’s dependence is much higher. It is estimated Europe utilizes Russian oil for about 30% of its total energy imports with Germany currently purchasing about half of its oil and natural gas from Russia.

Russia will feel the impact. Putting a ban on oil and gas imports is clearly aimed at the focal center of Russia’s economy. With oil and natural gas representing close to 60% of all Russian exports and 40% of its federal budget revenues, the ban strikes at the heart of Russia’s existing stature as the globe’s third-largest producer of oil and second largest of natural gas, as well as the country’s core economic foundation. Should other nation’s follow the U.S., the impact could quickly magnify.

There will be no free lunch for the U.S. or other Russian oil importing nations. The U.S. will need to either ramp up its own production or find alternative sources to make up for the gap in Russian oil imports. In the meantime, gas prices will likely continue to rise along with the broader consumer price environment. This could create a headwind for U.S. economic growth counteracting, to some degree, what we believe will be pent-up consumer demand in 2H 2022 stemming from rapidly declining COVID-19 cases.

In addition, the Russia-Ukraine war is now casting additional risk onto several other important factors facing the markets.

Inflation reports continue to reach multidecade highs. Most recently, the consumer price index (CPI) report for February posted a headline year-over-year jump of 7.9% and a core (ex food and energy) reading of 6.4%, representing the highest increases since January and August of 1982. It is extremely probable headline CPI will continue to see an accelerating upward pace into the summer months, particularly as gas prices rise against the backdrop of declining oil supply. 

The ongoing Ukraine crisis is broadening at a time when U.S. economic growth appears to be slowing in the short term. Current tracking by the Atlanta Fed of 1Q 2022 gross domestic product (GDP) growth is displaying a pace of less than 1%. Should final 1Q GDP growth post at close to such a level, a large chorus of stagflation concerns are likely to quickly emerge. 

Fed rate hike expectations remain fast and furious. We continue to believe the Federal Reserve will likely raise the federal funds rate to 1.00% by the conclusion of its July meeting and 1.50% by year end. We also believe the pace of inflation is likely to drive the 10-year Treasury yield into the mid-2% range by year end. 

Against this backdrop of market concerns and uncertainties, we encourage investors to also consider the following:

Brace for more volatility. Over the next few months, we are likely to continue seeing high market volatility as the war in Ukraine and other market uncertainties play out. That said, any legitimate resolution to the conflict in Ukraine, however distant that probability may seem at times, will very likely elicit a strong upside reversal in the market.

Employment numbers remain strong. Amid the backdrop of war, inflation, and declining 1Q economic growth, it is also important to recognize the exceptional job growth of recent months as evidenced by the January and February nonfarm payroll reports that, along with revisions to the November and December numbers, have added more than 1.9 million jobs to the U.S. economy and brought the unemployment rate back down to 3.8%. We believe this is mostly supply driven as those previously having left the labor force are starting to return in large numbers. 

COVID-19 cases are falling fast. At the height of the Omicron variant surge in mid-January, the seven-day average of new COVID cases exceeded 800,000. This past week, that metric fell to fewer than 40,000. With almost 90% of the U.S. now qualifying as either fully vaccinated or COVID recovered, the virus appears to be on its way to moving from pandemic to endemic status by year end. All else being equal, this should help to improve consumer demand and mitigate worker shortages. When taking the combination of these improving virus trends into account, along with the strong employment numbers, we see recession risk as low at this time and still believe CY 2022 GDP growth can reach 3% growth as pent-up consumer demand in the second half of the year should accelerate.

Credit spreads have widened to potentially opportunistic levels. In recent weeks, high-yield and investment-grade credit spreads have widened to their highest levels since 4Q 2020. Given what we believe is still a strong long-term economic picture, as well as solid credit fundamentals, these higher spreads off higher rates are now making for a more favorable income story across the bond markets.

1Q earnings reports will be crucial. Current estimates for S&P 500® net operating earnings growth in CY 2022 continue to hover in the 9% range with early estimates for 2023 growth at about 10% (FactSet Earnings Insight). Should these expectations remain intact following the upcoming 1Q reporting season, this could bode very well for stock prices in 2H 2022. 

Entry points more important than market bottoms. We also emphasize in these types of volatile markets that investors should focus on identifying favorable long-term entry points for stocks, which likely is where we currently are, rather than attempting to call market bottoms.

In summary, while the unfortunate developments in Ukraine combined with existing market uncertainties have cast a shadow of investor pessimism over the markets, we continue to believe there are long-term opportunities for equity and credit markets. Like most market sell-offs where investor confidence declines in lock step with stock prices, this market may take some time to regain its footing, during which it will probably prove ill-suited for those with faint hearts or short time horizons. However, even against a backdrop of rising rates, inflation, and war, we are still inclined to side with economic and corporate earnings growth in the year ahead inferring currently favorable entry points for stocks and certain credit-oriented bonds in the existing environment.

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