Russian de-escalation boosts sentiment, but for how long?
Geopolitical risk dominated market sentiment at the start of this week. While European stocks fell sharply on Monday, risk sentiment picked up during the US session after Russia’s foreign minister said that he would continue with diplomatic engagement with the west, hinting that there is still a chance that the Ukraine crisis could be resolved with talks. This was considered a sign that military tensions could be de-escalating between Moscow and the West, which boosted market sentiment late on Monday. One of the key issues for Russia is Ukraine’s membership of NATO, which it wants to ban. The new German Chancellor, Olaf Scholz, is due in Moscow on Tuesday for talks with President Putin. Ahead of his trip, he said that Alliance membership (for Ukraine) is practically not an issue and is not on the agenda. German and Russian diplomatic relations are considered to be on a better footing than US and UK relations with Moscow, thus, if market sentiment is to recover this week it could hinge on the outcome of talks between Putin and Scholz.
FTSE 100: IAG could unravel if EU rules are broken
European stocks managed to rebound from session lows after the comments from Russia’s foreign minister, and in the coming days we expect markets to be very news driven. If Russia does invade Ukraine at any stage this week, there were reports this weekend that an invasion could be come as early as this Wednesday, then expect global risk sentiment to fall sharply. As we have seen in recent sessions, also watch out for the White House’s reaction to events in Russia. On Friday, when the White House issued its first warning of an immediate threat of invasion by Russia in Ukraine, the S&P 500 sunk 2%. In the UK, losses on the FTSE 100 were broad-based, however, while geopolitics are impacting UK shares, Monday’s 5% decline for IAG is a keen reminder that threats of Russian military aggression is not the only risk factor for markets. A report from HSBC last week touted the possibility that due to the EU’s rules about ownership of airlines that travel within the EU, British Airways may have to demerge from IAG. If you fly within the EU, from Paris to Brussels for instance, then the airline needs to be owned by an EU company. Thus, Brexit is once more rearing its ugly head and knocking confidence in UK-listed companies. While the details of this rule and how it could affect IAG are still unclear, no doubt it would take a lengthy legal battle for any BA demerger to happen, the risk is that BA leaves the IAG group and the result is loss of value for shareholders, which is why IAG’s share price tanked at the start of this week. We expect IAG’s share price to be extremely sensitive to any more news on this story, and we would prefer the situation to be clarified before we would suggest picking up this stock at the recent lows.
Commodity supply crunch keeps prices elevated
Commodity markets are also in focus. On Monday, UK petrol and diesel prices rose to a fresh record high, which is another headache for the Bank of England to deal with. However, risk sentiment in the commodity markets could be harder to recover until there is a further de-escalation of the crisis between Russia and Ukraine. Waning stockpiles of key commodities for the global economy, including industrial metals, energy and agricultural commodities, have led to commodity markets flipping into backwardation, when spot prices are above futures prices, which is a sign that the market is panic buying due to scarcity. The problem is also spiralling, the huge increase in energy costs mean that smelters in Europe and China have been forced to cut production of metals including copper and aluminium, as they, ironically, have become too expensive to run. With no resolution in sight, this is likely to continue to drive up the price of commodities, which could keep inflation higher for longer periods of time. Also, demand pressures for batteries, could lead to demand for lithium, a key ingredient in many of the batteries used in “green tech”, outpacing supply by 6% this year. Thus, just as more governments plan to force their citizens to use electric cars, their prices are likely to surge. Right now, signs suggest that inflation will not fall quickly, and could continue to rise for the foreseeable future.
Inflation, not Russia the biggest driver of markets right now
While the Russian crisis is driving investors into some safe haven assets, the impact on markets has been harder to gauge due to looming fears about inflation and how the major central banks will deal with it. The biggest risk of war in Europe for over 70 years has not triggered a rush into US Treasuries, with the yield on 10-year Treasuries hovering at the 2% mark. Interestingly, the US Treasury yield is virtually ignoring events in Eastern Europe and instead focussing on the Fed and inflation risks. The US yield curve is flattening sharply, 2-year yields are close to 1.6%, which is a sign that the market thinks the Fed may overreact to inflation risks causing a sharp slowdown in economic growth in the coming years. Thus, growth fears are another reason why stocks may not recover quickly after a dismal quarter so far.
Fed watch gets serious
This week we are also watching Fed minutes that are released on Wednesday, to assess how likely a 50-basis point hike is at the March meeting. We will also be looking for any signals about how the Fed plans to shrink its enormous balance sheet and when it could start doing this. Signs that the Fed could start disposing of assets that it holds at the same time as embarking on an aggressive rate hiking cycle could weigh further on risk appetite. US Producer prices on Tuesday are also worth watching, while the market could be cheered by any slowdown in price growth, the risk is that price growth at the start of the inflation pipeline remains hot, which could mean that consumer prices do not peak in 1H, as the Fed expects.
European data in focus
UK CPI is released on Wednesday, and price growth is expected to land at 5.4%, a 30-year high. Another surge in prices could mean steeper and swifter interest rate increases from the BOE. The market will also be hoping that US retail sales bounced back in January, however the higher-than-expected inflation print in the US last month may have led to consumers focusing on necessities rather than discretionary items. European consumer sentiment, released on Friday, could see the impact of the Russia/ Ukraine crisis start to hit sentiment in Germany and Italy, both heavily reliant on gas supplies from Russia.
Trading through global risks
From a trading perspective, we continue to think that gold is worth watching. It is currently trading around the $1,867 mark, the highest level since November. A break above here could see a return to $2,000 per ounce. This level may be harder to reach if the threat of military force from Russia in the Ukraine is de-escalated in the coming days. We are also looking BP, the oil company’s share price fell by nearly 4% on Monday after concerns were raised about its reliance on its Russian business, this came even though the price of Brent soared to more than $95 per barrel. BP’s CEO swiftly released a statement to say that the crisis with the Ukraine is not impacting its Russian business, however an actual invasion by Russia could see further losses for BP’s share price in the coming days. GBP/USD is trading sideways at the start of this week, and we don’t think that a high inflation print later this week that has the potential to boost UK yields will benefit the pound. The market is now focussed on central banks smothering growth in the fight against inflation, since the BOE was the first major central bank to raise rates then the UK economy is on the firing line. Overall, we think that the balance of risks are for a lower GBP/USD in the medium-term. However, the pound is likely to outperform the euro, particularly during this period of geopolitical stress. Key support for EUR/GBP lies at 0.8310, a break below this level is a serious bearish development that opens the way to 0.80.