Economic Flash: Ukraine Conflict Takes Center Stage

city with orange streak

March 2022

US Economy: Inflation worries.

The US economy continued to grow in the first months of 2022, even if it wasn’t at the breakneck pace of 2021. Even as the Omicron variant of Covid abates, labor shortages and inflation persist as headwinds, with energy costs up sharply on a rebound in demand and now the Russia/Ukraine conflict.

US Stocks: Volatility surges.

US equity volatility hit a 2-year high, with a potential new cold war with Russia added to concerns. In Feb., energy (+7.1%) was the only sector of the S&P 500 in positive territory, while tech (-4.9%) and communications (-7.4%) were underperformers, with potentially higher interest rates a notable driver.

Foreign Stocks: Russia sanctioned.

International equities performed surprisingly in line with US equities, despite US dollar strength and the Russian stock market falling roughly 30% on the last day of Feb. Russian equities have become essentially “uninvestable” due to a variety of sanctions and removed from key global indexes.

Fixed Income: Munis shine.

The 10-year US Treasury yield rose as high as 2.1% on inflation concerns before dropping to near 1.8%, as the Russian invasion of Ukraine led investors to prize safe havens. In Feb. and so far in 2022, returns for municipal bonds have outpaced taxable bonds due to lower interest rate sensitivity and insulation from geopolitics.

Real Assets: Commodities squeeze.

Commodity prices continued to rise on ongoing concerns about accelerated inflation. Gains in Feb. were broad-based but highlighted by oil (+9.5%) as well as agricultural commodities (+8.9%.) Infrastructure equities outperformed broader equity portfolios but posted modestly negative performance.

Alternatives: Showing their values.

Hedge funds benefited portfolios in Feb. and into March, as they generally performed as well or better than fixed-income strategies in a difficult equity market environment. Relative value strategies underperformed (-1.3%) on somewhat indiscriminate selling.

Equities Total Return

U.S. Large Cap (3.0%) (8.0%) 16.4%
U.S. Small Cap 1.1% (8.7%) (6.0%)
U.S. Growth (4.0%) (12.5%) 10.3%
U.S. Value (1.0%) (3.5%) 14.4%
Int’l Developed (1.8%) (6.5%) 2.8%
Emerging Markets (3.0%) (4.8%) (10.7%)

Fixed Income Total Return

U.S. Agg. Bond (1.1%) (3.2%) (2.6%)
TIPS 0.9% (1.2%) 6.1%
U.S. High Yield (0.9%) (3.6%) 0.9%
Int’l Developed (1.1%) (3.3%) (9.0%)
Emerging Markets (0.5%) (0.8%) 0.3%
Intermediate Munis (0.4%) (2.8%) (1.8%)
Munis Broad Mkt (0.6%) (3.2%) (0.5%)

Non-Traditional Assets Total Return

Commodities 6.2% 15.6% 34.4%
REITs (3.9%) (11.5%) 21.8%
Infrastructure 2.5% 1.5% 15.1%
Hedge Funds
Absolute Return 0.0% (0.9%) 0.8%
Overall HF Market (0.4%) (1.8%) 0.4%
Managed Futures 2.5% 4.7% 9.3%

Economic Indicators

FEB-22 AUG-21 FEB-21
Equity Volatility 30.2 16.5 28.0
Implied Inflation 2.6% 2.3% 2.2%
Gold Spot $/OZ $1909 $1814 $1734
Oil ($/BBL) $101.0 $73.0 $66.1
U.S. Dollar Index 115.3 113.1 112.8

Glossary of Indices

Our Take

There are some months when interpreting market movements is seemingly straightforward and little stands out. However, this is not one of those months. While concerns over inflation and a more upbeat Covid-19 picture remain key market drivers, the Russian invasion of Ukraine has swiftly taken center stage. In the last few weeks, Russian forces have moved aggressively into Ukraine with the intention of shifting the balance of power in the region and reasserting Russia’s political and economic influence. In response, Western powers have formulated a lineup of economic and financial sanctions against Russia that are unprecedented in scope but have stopped short of directly entering the fight.

Given these unfortunate circumstances, there’s potential for a drawn-out conflict that leaves no discernible winners. The rising uncertainty has been appreciated by investors, a fact we are seeing play out in financial markets in the form of well-above-average volatility. While we are not experts in geopolitics at LNWM, we can identify likely near-term economic consequences and put the conflict in a longer-term perspective.

It is not known whether the western sanctions will have an impact on the course or term of the war, but they will almost certainly contribute to short-term meaningful disruption to the global supply chain and in the food and energy commodity markets in particular. The resulting disruptions are likely to fuel the fire of inflation, already kindled in the US and abroad. Additionally, financial markets have been characterized by risk-aversion as investors have shifted back into US Treasuries, moving yields lower and countering the narrative of rising US interest rates.

What We’re Doing

As wealth planners and long-term investors over many decades, we have shepherded clients through a variety of shocks to the capital markets — wars, a credit crisis, a pandemic, just to name a few. We draw on all that experience as well as market history to provide context when downside volatility fuels investors’ emotional and cognitive biases. While each conflict is different, and this one has the potential to change the complexion of Europe, geopolitical market shocks since the 1970s have tended to be short-lived. And we certainly hope that’s the case for the people of Ukraine.

In terms of the LNWM portfolios, we are glad to have allocations to diversifiers and risk- mitigators, such as high-quality bonds and also real assets, which may benefit from a sustained inflationary environment. And we have taken advantage of market volatility to rebalance portfolios as needed. If the Ukrainian conflict continues, these actions should be accretive to portfolios.

The rebalancing we undertook earlier in 2022 was largely about retaining the appropriate risk-return profile in client portfolios, whereas today we’re doing rebalancing mostly to top up equity allocations (where clients are underweight or have excess cash) as market selling may be creating a disconnect between prices and long-term fundamentals. Lastly, we’re looking to enhance net total return through tax-loss-harvesting strategies in a down market (a rarity prior to 2022), whereby we selectively realize losses that we can use to offset taxable gains.