“After 30 years of independence, the genie of Ukrainian national identity and statehood cannot be put back into the bottle, no matter how hard Putin tries.”
- From an essay in Foreign Affairs by Maria Popova, McGill University, and Oxana Shevel, Tufts University.
After a massive troop build-up on Ukraine’s borders, which many believed was a negotiating tactic by Russian President Vladimir Putin, on February 24 Russia invaded the sovereign nation. Global condemnation followed the biggest attack on a European state since World War II.
Dozens of countries imposed severe sanctions and corporations have been altering, halting or divesting their business there. MSCI eliminated Russia from its Emerging Markets Index. Fitch and Moody’s downgraded Russia’s credit rating to junk status, which will prompt more capital to flee Russian securities. The unified global response is unparalleled – even famously neutral Switzerland took a stand against this unprovoked invasion.
North American markets are far removed from and have little exposure to Russia. Volatility mostly occurred in commodity markets such as energy, metals and grain. This fuelled inflation and kept central banks headed toward tightening. Canada benefitted from rising commodity prices, but equity markets beyond our borders fell sharply in response to expected rate hikes and Russia’s assault on Ukraine. Bonds also slipped in February.
Canada – Continuing resiliency
Although Canada has limited trade exposure to Ukraine or Russia, the impact on price volatility for oil and natural gas is adding to inflation pressure. In January, inflation reached an annualized rate of 5.1%, its highest level since 1991. Food, energy and transportation led the way. Surging energy prices typically strengthen the Canadian dollar and blunt some of inflation’s bite. This time, however, our loonie has not appreciated, largely due to U.S. Federal Reserve hawkishness and the attractive safety of the U.S. greenback.
Our economy has continued to show resiliency. It grew 6.7% in Q4 of 2021 and 4.6% for all of 2021; GDP now sits above its previous high reached in Q4 of 2019. Surprisingly, StatCan estimates the economy actually grew 0.2% in January despite significant Omicron-related shutdowns. February numbers will likely be lower thanks to ongoing supply-chain logjams, fallout from the truck convoy protests, and elevated energy prices.
In an effort to curb inflation, the Bank of Canada (BoC) raised its benchmark interest rate 25 basis points to 0.5%, its first hike since 2018. Five or six more hikes are expected in this cycle. Market watchers are now focused on the speed and magnitude of future hikes as the BoC attempts to walk a fine line between calming inflation and stifling growth.
Despite significant world events and volatility, the S&P/TSX ended February essentially flat. Materials and energy soared while information technology took a beating. Responding to supply-chain tightness and geopolitical disruptions, West Texas Intermediate (WTI) oil rallied above US$95 per barrel in February. Gold also climbed on inflationary concerns and a risk-off environment, rising above US$1,900 per ounce. The 10-year government bond yield rose 10 basis points to 1.8% while the two-year bond yield increased by 20 basis points, flattening the curve to reflect more short-term interest rate hikes but not necessarily overall persistent economic growth.
U.S. – Strong response against the invader
U.S. President Joe Biden joined world leaders in imposing wide-ranging sanctions designed to cripple Russia’s economy. The U.S. and the European Union (EU) want to cut off Russian financial institutions from Western financing and undermine support for Vladimir Putin by going after the assets of his wealthy inner circle of oligarchs. The U.S. is repositioning some of its 90,000 Europe-based military members to shore up the defence of NATO nations bordering Ukraine. President Biden has maintained that these moves are temporary, and has stated that the U.S. will only enter the conflict if a fellow NATO member comes under attack. CBS News quoted financier and anti-corruption activist Bill Browder as saying, “There’s an expression: We should fight them in the banks if we can’t fight them with tanks.”
The U.S. economy started 2022 on a strong note. Even though January’s inflation hit 7.5%, the highest level since 1982, consumer spending (which accounts for two thirds of the U.S. economy) increased by 2.1% after falling 0.8% in December. Strong wage growth in a tightening labour market encouraged shoppers to take out their wallets. This helped offset a reduction in government aid and rising prices. The U.S. economy grew at an annualized pace of 7% during Q4 of 2021, a dramatic increase from 2.3% in Q3. However, the economy faced significant headwinds through the first two months of 2022 and the tempo of expansion is expected to slow substantially.
The Federal Reserve has said the war is unlikely to alter its plans to tighten U.S. monetary policy. Analysts expect the central bank to raise its benchmark rate from zero when it meets in March. There is some debate whether the standard quarter-point increase will be enough to slow rampant inflation, or if a half-point increase is warranted. The market is now pricing in a lower probability that an aggressive hike of 50 basis points will be the Fed’s next move.
Heightened volatility caused by war in Ukraine plus rising inflation are roiling U.S. markets. The broader S&P 500 fell into correction territory for the year so far and plummeted 3.1% in February. Rising rates are challenging for tech companies; the Nasdaq Composite fell 3.4% during the month.
Europe – EU to deliver weapons
The EU has imposed severe sanctions on Russia. One of these sanctions aims to punish Russian banks by cutting them off from the Society for Worldwide Interbank Financial Telecommunication (SWIFT), a secure messaging network for banks that enables them to quickly and securely facilitate cross-border money transfers. This will create difficulties for approximately 70% of Russian banking and prevent affected banks from conducting most financial transactions worldwide.
In a watershed moment in its history, the EU agreed to finance and deliver weapons, which will go to the Ukrainian military. Approximately 450 million euros will pay for lethal arms and another 50 million euros will buy supplies such as fuel and medical equipment. In addition, European nations shut their airspace to Russian aircraft, and banned the export, sale, supply and transfer of aircraft or related equipment to Russia.
European Central Bank head Christine Lagarde stated: “What we know is that the two main channels through which the euro area economy will be affected will be through energy prices and through confidence or the uncertainty channel; not so much through trade, which is limited between Russia and the euro area. Persistent uncertainty will probably be a drag on consumption and investment, and will impede growth.”
Although the EU is drafting plans to reduce its reliance on Russian gas, war in Ukraine makes growth even more uncertain. The European Commission (EC) estimates that economic growth in February will come in at 4.0% for the 19 eurozone countries, below November’s 4.3% forecast. The EC believes growth was hampered by COVID-19, supply-chain disruptions, and inflation driven by energy prices.
Geopolitical tensions suppressed February markets. The Euro Stoxx 50, FTSE 100, and DAX fell by 7.1%, 1.0%, and 7.4%, respectively.
China – Slowing growth
China plans to increase tax cuts and raise payments to local governments in order to offset slowing growth. Finance Minister Liu Kun said, “This year, the central government will significantly increase the size of transfer payments, especially general transfer payments, continue to favour regions with difficulties and underdeveloped areas.”
These efforts are aimed at supporting a slumping economy, which began to lose momentum in mid-2021 due to debt problems in the property sector and COVID-19 restrictions that dampened consumer spending. The exact size of the tax and fee cuts and special bond issuance for 2022 will be released at the National People's Congress annual meeting this month.
For February, the Hang Seng posted a negative return of 7.6% after Western sanctions on Russia made commodity prices surge. The Shanghai Composite posted a slightly positive return of 1.0%.
Japan – Crisis poses risks
Japan’s factory output contracted 1.3% in January, reflecting the auto sector’s struggle with production suspensions in the wake of a tsunami of COVID-19 infections. Output fell for a second straight month, following a 1.0% drop in December. Retail sales were also down a seasonally adjusted 1.9% in January. The crisis in Ukraine poses serious risks to Japan’s output and overall economy. Continued conflict could trigger a global commodity and energy shortage.
The Bank of Japan said it’s too soon to begin tightening monetary policy and withdrawing the massive stimulus program, given the country’s low level of inflation.
The Nikkei fell 2.0% in February, with investors focused on fighting in Ukraine.
Our strategy
On the strength of commodities prices, which were bolstered by the unprovoked Russian invasion, Canadian equities significantly outperformed both bonds and global equities. As a result, some of our portfolios now have an overweight allocation to Canadian equities. We believe there are strong, short-term, positive drivers for our stock market. Market volatility has made rushed rebalancing imprudent.
Our explicit asset allocation call is to be overweight U.S. equities, which is reflected in most client portfolios. Given their recent underperformance, we believe U.S. equities are now even more attractive.
The last word
Our thoughts are with the people of Ukraine, the 1.4 million Ukrainian-Canadians and all those around the world affected by this tragic, ongoing invasion.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
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