Ukraine & Inflation – what does it all mean?

Investment markets are currently being driven by two risk events:

1. Inflation and rising central bank interest rates
2. Russia / Ukraine conflict

In isolation, market sentiment would’ve settled already. However, markets are struggling right now to account for the combination of both and the spectre of both feeding off or into each other.

What we’ve been trying to do is to separate the following two factors in relation to the two risks in question:

1. Sentiment
2. Direct implications

Sentiment isn’t based on fundamentals, rather it’s behavioural, but it’s also not something we can ignore. Right now, the sentiment to both risks are deeply negative, however we consider this is rather irrational in that we feel it’s overblown from a financial/economic perspective. The main reasons for this are:

1. Whilst inflation is high in some jurisdictions and rising in others, we don’t think central banks will raise rates aggressively and we don’t think they can get rates significantly higher from here in the short term
2. Whilst the conflict is terrible for all involved, both directly and indirectly. We consider there is likely a deal to be done.

Given this, we think sentiment indicators are too negative, and this in isolation presents an opportunity to very selectively add to portfolios for those with a greater risk appetite, a longer investment horizon and surplus cash.

However, we must also consider the direct implications of both risks on economies (e.g. recession) and markets (e.g. earnings).

In terms of the inflation problem, which is further exacerbated in terms of energy prices by the conflict, there are direct implications for:

1. Earnings – how does inflation impact demand, supply, profit margins, and costs?
2. Valuations – how do rising interest rates, in order to fight inflation, impact valuation sensitivities (e.g. will expensive stocks remain under pressure)?
3. Balance Sheet – how do rising interest rates impact corporate balance sheets and cashflows?

In terms of the conflict, and the longer it takes to achieve a resolution, there are direct implications for:

1. Economic growth – the probability of a European recession is rising and negative economic spill over to other economies
2. Commodities – both supply and prices, which will benefit some nations (commodity exporters) and hurt others (commodity importers)
3. Government balance sheets – further strain on government balance sheets in terms of defence spending and potentially more stimulus (if required)

Perversely, the direct implications of the conflict aren’t necessarily bad for markets as it means the central banks won’t be able to raise rates aggressively and governments may need to be more supportive.

Coming back to the main prevailing risks right now, sentiment is clearly negative at present. But the counter to this is that companies are fundamentally in very good shape – earnings are strong and robust; balance sheets are relatively clean. Europe is the most adversely affected by the conflict and could possibly tip into recession this year. Obviously this is bad for Europe, especially given weak economic growth over the last 10 years or so, but that could prove to be a positive for the US, Australia, and some emerging market countries.

At this point, while of course the conflict and the cost of human lives is terrible to witness, it is also negative news flow, but it is not necessarily impacting company fundamentals. This was a similar dynamic when we commented on COVID and the lockdowns first experience in 2020. While we hate to see the health and human implications, these do not always have an equal impact financially. We also think investment markets will get their much sought-after clarity on the likely US interest rate path over the next month or so.

With that said, we remain comfortable with being invested right now – meaning we are not looking to take risk off the table/sell investments. If anything, we’re looking for an opportunity to add to portfolios and often consider doing this gradually rather than trying to pinpoint a specific entry date.