Confusion reigns: hopes for the G7 meeting could boost sentiment

The biggest event this week could end up being the virtual G7 summit on Thursday, that will see the world’s biggest leaders taking steps to de-escalate the issues with Russia and Ukraine and ultimately resolve the crisis without military intervention. However, the markets are not convinced, and remain wary of news flow surrounding this crisis. For example, after sentiment initially bounced on reports that US President Biden would potentially hold a summit with Russian president Putin this week, the Kremlin lowered expectations for such a meeting by saying that there were no concrete plans that this meeting would take place at the same time as not ruling out this option. The news-flow is confusing, and this is why European markets are weaker at the start of this week. 

Invasion: will they or won’t they 

The sell-off was sharpest for the German index, followed by the French index, with the UK looking more protected, the FTSE 100 fell 0.43% so far on Monday. Market sentiment during the European session was not helped by news that Moscow had killed five Ukrainian soldiers who had crossed into Russia. This sent shock waves through assets that are sensitive to this conflict: USD/RUB rose by more than 2% close to a fresh all-time high above 79.00 and Brent crude oil also rose by more than 1%, reversing earlier losses. Sentiment started to pick up after officials in Kyiv said that Russia’s claims to have killed soldiers was “fake news”, with the euro rising a touch to above $1.1335, and Bitcoin also jumping back above the $38,000 level. This highlights how confusing the news flow is right now, and also how the market is prepping for a bad moment in this crisis. 

Risks other than Russia: expectations for a hawkish Fed 

While volatility and lower market tops suggest that investors are getting cold feet, it is tempting to put current market action just down to geopolitical issues, however, the prospect of an aggressive Fed tightening cycle is still with us, and the loss of abundant and predictable market liquidity could hurt markets for some time. This week we will get January’s PCE price data from the US. The personal consumption index is the Fed’s preferred measure of inflation, and it is expected to rise by 0.3% MoM to an annual rate of expansion of 5.5%, down from 5.8% in December. This is still an elevated number; however, it could boost sentiment and reduce expectations for a 50-basis point increase in the Fed Funds rate next month. According to the CME’s Fedwatch Tool, there is now more than 80% chance of a 25-basis point increase in the Fed Funds rate to 25-50 bps at the March meeting, with a 60% chance that rates will move to 75-100bps by June. This suggests that the market is still expecting the Fed to belatedly tackle decades- high inflation that, so far, remains persistent. Not only is the cost of capital expected to surge, but the Fed may also talk about contracting its balance sheet when it meets next month, that means lower levels of liquidity in the future. Since the Fed is still pumping liquidity into financial markets each month, and market sentiment already remains shaky, it could be a rough few months for equities and this may keep volatility elevated even if the geopolitical risks are dampened down later this week. 

Stronger European data can’t stem equity weakness, for now 

The declining levels of Omicron, the return of tourism and the lifting of lockdown restrictions helped to boost PMI reports for Europe for February. These preliminary PMI reports showed that Eurozone composite PMI rose to 55.8 in Feb, beating expectations of 52.7, and up from 52.3 in January. In the UK the rebound was stronger, with the service sector rising to 60.8 from 54.1 in January. The fact that stronger economic data is not soothing European stock indices suggest that financial markets want further confirmation that the Russia/ Ukraine conflict can be resolved using diplomatic means. This is still not a certainty at this stage. We would note that there was some clawing back of losses towards the end of the European session, however, we will look to the US market open on Tuesday, US markets are closed on Monday, for more direction. 

Why individual stocks are in favour 

In this environment we prefer individual stocks, and we would note that UK equities that continue to outperform in the short term include Astra Zeneca, after it updated the market on positive data from a breast cancer drug. We picked the healthcare sector as one of our favourites for this year, and we expect it to continue to outperform in the current environment. Associated British Foods and Reckitt Benckiser are also top performers and remain good defensive stocks to hold when the overall index is under pressure. Analysts at Deutsche Bank have said that US stock sell offs triggered by geopolitical events tend to be short lived, about 3-weeks in total, with another 3 weeks for markets to regain losses. The median drop in stocks during this period is just under 6%. Thus, if Russia does not invade the Ukraine, in the next week or so, markets could lose interest and focus on other areas, namely the Fed, before it starts to recover. 

A word on gold…

The precious metal is outperforming equities and bonds as investors seek safe havens. This is not unexpected, especially as volatility in the US Treasury bond market is at its highest level since the start of the Covid pandemic. Although gold has eased back from its break above $1,900 per ounce on Friday, the potential for a geopolitical crisis and global central bankers to make a policy mistake that leads to elevated inflation risks, could push gold above $1,950 per ounce over the next month or so. The increase in the gold price is even more impressive since it appears to have broken the relationship between rising real yields, which tends to lead to a weaker gold price. This suggests that the market is seriously concerned about inflation remaining sticky at this high level at the same time as the economy starts to weaken. Any signs of weaker economic data from the US, including the February PMI data due for release on Tuesday, could lead to further gains for gold in the short term.