Russia dominates sentiment as markets remain wary of “good news”

Markets struggled to claw back any recent losses on Friday, and not even a spate of strong economic data including strong retail sales for the US and the UK and better than expected Eurozone industrial production were enough to boost sentiment after dramatic declines in risk assets on Thursday. The markets are focussed on geopolitical tensions and the Russia/ Ukraine crisis. While Russia has still not invaded Ukraine, there remains a war of words and continued ‘Cold War’ style tactics from Russia. The issue for traders is that even though Russia has said that it will continue to engage in talks with Ukraine and the West to resolve this crisis, it continues to up the stakes. For example, on Friday, Russian backed separatists in the eastern Donbar region of the Ukraine said that they were evacuating their citizens to Russia, which is adding to western fears that an invasion is still imminent. This is keeping market jitters high, and we expect traders to remain on edge for some time. 

Dissecting this crisis and how it impacts markets leads us to three conclusions, which we will outline below.

1, As we mention above, the markets are wary about trusting what Russia is saying about continuing talks with the West and avoiding military action, while at the same time increasing troop presence around the boarders with Ukraine and also unveiling plans for nuclear drills to test its ballistic and cruise missiles. This hardly seems like the actions of a country determined to avoid armed conflict. This week financial markets have fallen sharply on the back of two main drivers: when the threat of chemical or nuclear warfare gets mentioned, or when the US or UK authorities claim that a Russian invasion of Ukraine is imminent. The markets are trusting the information that they are given from the West much more than what comes from Putin in Russia. Market psychology is important at the moment, so if we hear any more pessimistic announcements from Western leaders in the coming days, then we could see further declines for risk assets at the start of next week. Overall, we think that stock market volatility will remain elevated until the geopolitical risks have died down. Until then defensive stocks like Reckitt Benckiser Group, Imperial Products Group, BT and the oil majors should continue to outperform. 

2,The transmission mechanism between geopolitical risks around Russia and financial markets is based on a potential invasion of Ukraine by Russia leading to a spike higher in the oil price feeding global inflationary pressures. This would then lead to a more aggressive Fed, which is why stock markets are so on edge. Even before the Russia/ Ukraine crisis the Fed was expected to hike rates at a rapid clip this year, with investment banks like Morgan Stanley expecting 6 rate hikes in 2022. The oil price is the key metric to watch during this period of elevated geopolitical tension. On Friday, the Brent crude oil price reversed earlier losses and surged back above $93 per barrel ahead of the European market close after reports circulated about shelling in Eastern Ukraine and the mass evacuation of civilians. Biden and other Western leaders are expected to meet on Friday to discuss this latest development. At the time of writing, we do not know the outcome of this meeting, however if it involves sanctions against Russia then we could see Moscow retaliate by blocking off oil and other energy supplies to Europe, which is adding to the inflationary threats perceived by markets. While markets are reactionary to the latest news developments, the reaction in asset prices this week suggests that financial markets realise that Russia holds the upper hand over the West in this crisis, and whether or not tensions are escalated or scaled down will depend on Putin, which is not filling markets with confidence. 

3, While commodity and stock markets are in focus, we are also following the Treasury markets this week. US Treasury markets have been hit by their most serious bout of volatility since the start of the Covid pandemic in 2020. Treasuries are facing a troika of issues right now including rapidly rising inflation, geopolitical concerns and the prospect of an aggressive Fed tightening cycle, which is also being driven by concerns in Russia. Every economic data report, Fed speech or news update on the Russia/ Ukraine crisis is having an outsized impact on US government debt. This is one reason why the world’s most liquid asset is not acting as a safe haven in the latest market storm. US 10-year Treasury yields have only fallen approx. 7 basis points this week, and are currently trading at 1.94%, suggesting that investors are not willing to buy US government debt when the Russia/ Ukraine crisis is perceived as being both a military and inflationary threat. 2-year treasury yields, which are most sensitive to near term changes in Fed policy, also remain elevated at 1.47%. A flattening US yield curve is also another sign that the Russia/ Ukraine crisis could have harsh economic consequences for the West. However, we do think that the current situation will hinder the Fed’s ability to tighten policy, and they may have to delay plans to shrink their $9 trillion balance sheet when they meet in March, which may give markets some comfort in the coming weeks. 

As you can see, the balance of risks for the global economy are tilted to the downside. The surge in the Brent crude price at the European close on Friday is a sign that investors are buying into any dip in commodity prices. Aside from defensive sectors, we don’t think that stocks will recover until the threat of a Russian invasion in Ukraine has been neutralised. The FX market is acting like a wallflower at the moment, with the focus on commodities and bonds. However, the euro is likely to remain biased to further losses until the crisis is resolved. The best piece of advice we can leave traders ahead of the weekend is to watch out for comments from western leaders, as the markets are following their updates more closely than they are comments from Moscow.