Ukraine is not yet a markets crisis

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Good morning. Ethan here; Rob’s back next week.

It has been a grim for a few days. Events have moved faster than ours, or at least my, ability to process them. Within recent memory, you could find respectable commentators writing that Russia might be bluffing about invading Ukraine. I have no special insight into power politics or warfare, but clearly that was wrong. Now all that’s left is pondering the consequences. Today, I try to do so.

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Ukraine: either little changes, or everything does

A hot war is under way in Ukraine. Massive retaliatory sanctions are being rolled out and energy prices are soaring. Yet the S&P 500 closed up 1.5 per cent after selling off hard in the morning.

By now, ridiculous intraday swings feel like the norm for US stocks. But on Thursday all types of assets swung in value. Oil rose above $ 105 a barrel but settled below $ 100 after Joe Biden said US sanctions would not hit Russian energy groups (yet). Gold traded as high as $ 1,974 a troy ounce and as low as $ 1,878. Treasury inflation-protected securities opened and closed at similar levels, but only after a huge lurch:

Line chart of Ukraine invasion roils inflation-linked US Treasuries showing Fog of war

One interpretation is that investors have no clue what’s going to happen. Extreme scenarios are on the table, such as cyber attacks on critical infrastructure or a wide-reaching international conflict.

Uncertainty is making accurate pricing difficult, especially in Ukraine and Russia. With investors fearing the worst, Russia’s main stock index plummeted 26 per cent. Credit default swap markets are pricing an 83 per cent probability of Ukraine defaulting on its debt in the next five years. The price of Russian and Ukrainian commodity exports are surging. Their byproducts, like live hogs that in China are often fed on Ukrainian corn, are rising too. The price of oil is jumping, although tight fundamentals are the main cause of expensive energy. Much of this will be painful, especially in poorer countries that must import commodities.

The whipsawing in broader stock indices such as the S&P 500, however, are harder to explain. This is partly a side-effect of hedge funds closing out short positions, as the FT’s Eric Platt sniffed out:

Hedge funds were closing out short trades, bets that a stock or exchange traded fund would decline in value, as they sought to reduce their exposure given the market volatility, the head of one of the largest trading desks on Wall Street said.

To cover those short positions, funds bought the underlying stocks and ETFs they had bet against, helping to buoy the entire market, traders said. Several pointed to the advance in prices of heavily shorted stocks, including Ark Invest’s flagship Innovation ETF, as a sign of the move by hedge funds.

Couple that explanation with the big picture: that for most investors the invasion’s impact has been limited. Markets are priced for a medium-term disruption in certain sectors, but not yet a broader disaster.

You can see this in haven assets, where the flight to safety has looked measured. The dollar and yen have appreciated, but the changes are too small to suggest widespread fear. The US dollar index rose less than a percentage point on Thursday. Yields fell at magnitudes reminiscent of a moderately dovish central bank surprise (ie, 10 or so basis points). Likewise, gold has been rising, but zoom out and the change doesn’t look so precipitous:

Line chart of Despite a recent rise, gold prices are within their recent range showing Well-trodden ground

It’s worth remembering that almost all the economic fundamentals in place last week are in place today. A global rate rising cycle still looms and US growth is still sturdy. On Wednesday, Invesco’s Kristina Hooper told me she thinks central bank tightening is a bigger risk to markets than Ukraine. In the wake of Russia’s invasion on Thursday, I asked if her mind had changed. Here’s Hooper:

No, my response hasn’t changed much. We are still not in a full-scale war. Putin has invaded Ukraine with military force, but as of now, the US and allies are not expected to retaliate with military force – just economic sanctions. Hence the strong rebound today after the major stock market drop. So at least for now, I think central bank tightening is still a bigger driver for the US stock market over the medium term.

The war’s effect on central bank action is a question that lingers large. On Thursday, European Central Bank governor Robert Holzmann told Bloomberg that the Ukraine crisis could postpone the end of monetary stimulus. But as frequent Unhedged correspondent Dec Mullarkey of SLC Management pointed out, central banks are probably in a bigger pinch than they’d like to admit:

Russia supplies 40 per cent of Europe’s gas and 20 per cent of its oil. If sanctions were to limit Russia’s energy exports or [if] Russia retaliates by withholding supply, energy prices would jump.

The risk of an energy driven inflation spike is high and the danger is that it will choke growth. That puts central banks in a box where they don’t want to hold back as inflation persists but if they hike rates too quickly they could force an abrupt slowdown. So the compromise is to tread carefully with measured hikes. That is what we are seeing in the current yield curve moves.

Traders in overnight funding markets seem to agree; the invasion has not moved the consensus guess of how much the Federal Reserve will raise rates. Stronger US growth and Russia’s energy threat to Europe could leave the Fed with a clearer path forward than the ECB, as Strategas’ Don Rissmiller wrote on Thursday:

Recession risk is increasing in Europe, as energy prices surge. But lost in the recent headlines, US initial jobless claims declined w / w to 232,000, indicating a tight US labor market.

So, there’s not enough global weakness, yet, to stop a hawkish Fed. This leaves Europe in a tough position. European growth (which was already choppy) matters for multinational company earnings, which are likely at increased risk even if a US recession is not our base case.

The story that markets are telling is of a medium-term contained disruption. That is bad, but not catastrophic. More ominously, tail risks have multiplied. If the war spreads to other countries, it is dire for markets, let alone the world. In a year’s time, either this war will have changed a little about markets, or changed everything.

One good read

Taiwan is not Ukraine.

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