· Geopolitical turmoil is fueling fear of escalation and recession. The conflict in Ukraine could linger, but positive signs from the U.S. administration point to a strong desire to avoid a direct confrontation with Russia.
· We think Canada remains best positioned to navigate both the direct impact of Russian sanctions, which should weigh more on Europe, and the increase in commodity prices, Canada’s number-one export. Our expectations for global economic growth and corporate earnings are negatively impacted because of the conflict. We think the market’s reaction reflects a high a probability of a recession or military escalation.
· We remain overweight of equities, but because we don’t expect near-term progress toward peace, we remain cautious in buying equity dips until the political landscape improves. On a regional basis, we remain biased toward Canadian equities, neutral on U.S., and underweight to Europe, Australasia, and the Far East (EAFE) and Emerging Markets (EM), We are also underweight on duration.
· On a sector basis, we remain overweight of U.S. financials and the international travel sector, and we reduced our overweight to the U.S. energy sector.
The Russian invasion of Ukraine has caused a wide array of concerns for investors, including fear over a potential broadening of the most significant military conflict in Europe since World War II.
While the weight of Russia (less than 3%; Source: Statistia.) and Ukraine (less than 0.01%; Source: Trading Economics) in the global economy were relatively small before the conflict broke out, Russia is a key supplier of commodities, from oil, natural gas, metals, and grains, and the conflict has sent the price of various commodities surging.
While the consequences of the conflict expanding could be dire, we think regional escalation will be avoided. However, it’s likely the conflict may persist for several weeks and further weigh on investor sentiment, although we would nevertheless expect the conflict to have a small negative impact on global economic activity, especially in North America where we think the downside risks are lower, in contrast to Europe.
Chart 1: Commodity Prices Surging on Geopolitical Turmoil
The chart plots the history of commodity indices (energy, industrial metals, and agricultural products since 2015). We see a sharp increase in recent days after a steady upward trend that began in 2021.
Source: Bloomberg, BMO Global Asset Management, as of March 11th.
Global Markets in February: Fear of war and economic sanctions against Russia roil markets
Global equities (MSCI ACWI, -2.6%) registered their second consecutive loss in February as Russia invaded Ukraine. While Canadian equities (S&P TSX, +0.3%) were once again shielded from the global market turmoil and managed to register a small gain as the energy sector surged along with oil prices. In the U.S., the S&P 500 (-3.0%) was pulled lower by its tech leaders as the Nasdaq 100 (-4.5%) underperformed. The brightest spot in the U.S. in February was small-caps (Russell 2000, +1.1%), which are more shielded to global turmoil because they are more domestically focused, in contrast to large-cap stocks, whose earnings are more globally driven. Europe, Australasia, and the Far East (MSCI EAFE, -1.7%) equities outperformed during the month but lost ground late in February versus other regions as the conflict broke out and began hurting European equities severely (Euro Stoxx 50, -5.9%) because of the significant commercial linkages between Europe, Russia and Ukraine. Emerging-market (EM) equities (MSCI EM, -3.0%) also fell as Russian equities suffered steep losses in February before collapsing to a dramatic valuation of zero in March. Finally, Chinese equities (MSCI China, -3.7%) continued to underperform both the EM complex and global equities as the country continues to face growth and policy headwinds.
Despite the drums of war spooking markets, the inflationary backdrop that dominated the central-bank policy outlook in recent months kept interest rates under upward pressure in February. The yield on Canada’s 10yr bond edged higher by 4bp despite the geopolitical turmoil and equity losses. Fear over oil supplies sent oil prices to cyclical highs (Western Texas Intermediate, +8.6%) to end the month at $95.72/bbl, while prices approached $130 in early March as fear peaked. Risk aversion, and the better relative positioning of the U.S. compared to Europe surrounding the geopolitical turmoil, has helped the U.S. Dollar register a small gain (DXY Dollar Index, +0.2%) during the month. The surge in oil prices helped the Canadian dollar gain 0.3% against the U.S. Dollar. Finally, the VIX volatility index continued to swing along with equity prices this year and climbed from 25% to 30% as investor anxiety deteriorated and equities continued to struggle. As a technical indicator, we would see a VIX rising above 40% as a tactical re-entry point for U.S. equities.
The S&P 500 in Times of Turmoil: Geopolitical fear tends to offer buying opportunities
Looking back at the S&P 500 since World War II and a series of major wars and terrorist attacks since then (Table 1), we see that even in the most dramatic cases, equities have generally experienced mild and short-lived pain. What matters most for equity returns are always large recessions, most often triggered by large macro excesses (i.e., debt, leverage) where a wave of layoffs and credit default is triggered. Although global growth expectations are coming down, we think recession risks remain very low, unless the conflict deteriorates significantly.
Table 1: Impact of Major Geopolitical and Terrorist Events since World War II
Source: LPL Research, S&P Dow Jones Indices, CFRA, BMO Global Asset Management
Should we Fear a Recession if the Conflict Remains Contained to Ukraine?
Between the uncertainty of the war, sanctions, supply disruptions, and the surge of commodity prices, threats to the global economy are adding up because of the conflict in Ukraine. Regionally, however, the downside risks to the economy are quite different. While the Russian economy will likely suffer a tremendous blow by losing access to its major trading partners and a collapsing currency, we think the European economy is the most negatively exposed region for all the reasons listed above. The challenges of replacing supplies of Russian energy could take Europe years to fix (Source: Politico). In the U.S., we think the main threat to the economic outlook is the additional tailwind to inflation, most notably for gasoline prices, which will eat into consumers’ purchasing power. We think this risk is manageable since the job markets in the U.S. and Canada are running hot (Source: Bloomberg).
The surge in oil prices is helping Canada’s trade balance reach its highest surplus since 2008 (Chart 2).
While the Canadian economy is not sheltered from global turmoil, it’s nevertheless the developed economy which we think is best positioned to sustain higher commodity prices given that commodity exports play a major role in the economy. This has been one of the key reasons we are maintaining an overweight on Canadian equities as we fear the conflict could linger and weigh on Europe and EM countries.
Consumers probably pose the biggest threat to the economic outlook. We expect consumers to experience heightened inflationary (like a tax) pressure and loss of purchasing power, which could slow 2022 economic growth. But because the economy is still in healing mode from the pandemic, with lingering supply issues, accompanied with cash-rich households and full employment, we think a U.S. recession is unlikely.
Chart 2: Canada’s International Trade Balance at Highest Since 2005
The chart shows the history of Canada’s international trade balance since 2005. The trade surplus rose sharply in recent months as commodity prices rebounded
Thoughts on the Outlook for the Conflict
We interpret the reluctance of the U.S. to implement a “no fly zone” over Ukraine or the refusal to allow for Polish fighter jets to be sent to Ukraine as important positive signs that the U.S. administration carefully seeks to avoid a dangerous escalation with Russia. However, a cease-fire agreement between Russia and Ukraine remains elusive. We expect the U.S. and its Allies to leave its policy focus on costly, targeted economic sanctions. A scenario that would draw other countries into the conflict would be reason for alarm and bring more severe human and economic consequences, however, we think such a scenario will be avoided given its uncertain and costly outcome for all parties involved. For Ukraine, sadly, we expect very difficult times still lie ahead, unless Russia suddenly ends its goal to conquer Ukraine. Finally, because of the severe economic costs on Russia, we think the conflict could be relatively short (months) rather than drag on for years. While further equity downside would probably require a worsening of the conflict, any signs that progress is made on peace could spark a sharp rebound in equities like the ones we saw on March 9th.
Central-Bank Outlook: Inflation requires to take the foot off the gas pedal
Now that the rates liftoff is behind us with both the Bank of Canada and the U.S. Federal Reserve having hiked by 25bp, we still expect an easy hiking to near 2% over the next twelve months to normalize policy and remove the stimulus of ultra-low interest rates. While we expect the economic outlook to be resilient to rate hikes and geopolitical turmoil in Ukraine, we think
central banks would be pragmatic enough to adjust their policy outlook if economic conditions weakened more than expected. Lastly, because the inflation overshoot may persist into 2023, we expect greater tolerance by central banks
for inflation to run closer to 3% over the medium-term, rather than the previous 2% anchor.
For the near-term, we don’t expect a meaningful drag on U.S. growth although consumers are spending (a lot) more to fill up their gas tank and the rate of consumer price inflation will easily be above 8% in the upcoming inflation report for March. More importantly, we think corporate earnings will be more resilient than expected as the fear regarding economic growth is overdone, especially in the U.S. Finally, we would expect to see a sharp rise in equity prices if the conflict was to suddenly end. We think the equity market is currently pricing in a high probability of a recession in Europe.
Although we continue to prefer Canadian equities, the degree of negativity on European equities leaves them increasingly attractively valued, albeit still negatively exposed to lingering turmoil in Ukraine. For reasons highlighted above, we downgraded EAFE and EM equities to underweight while downgraded the U.S. to neutral. On a sector basis, we remain overweight of U.S. financials and U.S. energy, two sectors that have outperformed year-to-date. We are also overweight of the international travel sectors, which has suffered renewed negativity as oil prices and the fear of war surged. Our original thesis on this sector was to expect a rebound of the international tourism industry over the next eighteen to twenty-four months and we maintain that view. In fixed income, we are underweight of interest-rate duration.
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