The Rising Costs of a Drawn-Out War

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class, Neuberger Berman

Financial markets may not ebb and flow with major developments on the battlefield anymore, but we believe they do still need to come to terms with the war’s lasting inflationary impact.

A month ago, Joe Amato wrote about how financial markets were refocusing on economic fundamentals following the shock of Russia’s invasion of Ukraine.

He added an important caveat, however, echoed in our recent Asset Allocation Committee debates: While most geopolitical shocks do not have a lasting impact on the economy and markets, those that exacerbate existing fundamental issues often do.

The invasion of Ukraine is an inflationary shock to an already inflationary system. And markets—especially government bond markets—have become increasingly sensitive to inflation data and sentiment on interest rates.

The growing prospect of a long war is therefore an important element of the current market environment. Stock, bond and commodity prices may not ebb and flow with major developments on the battlefield or the geopolitical scene anymore, but we believe they do still need to come to terms with the war’s lasting inflationary impact.

Thwarted

In the first two months of this war, Russia’s ambitions for a quick victory were thwarted. To repel the invasion completely, however, is a forbidding task for Ukraine. Talks appear to be stalled, with both sides digging in for a long fight.

In the immediate term, that means the energy and food shortages beginning to be felt in Europe and elsewhere are likely to worsen. The International Energy Agency (IEA) has warned that the impact on oil supply will peak only from May onwards—leaving the world with a three-million-barrel-a-day hole to fill. We think that means $100/bbl oil for the foreseeable future, with risk skewed to the upside.

The International Monetary Fund’s latest outlook reflects the economic toll of those high prices: it has raised its inflation forecast for 2022, while cutting its global growth forecast to 3.6%.

Globalization

As the war drags on, we think the risk of longer-lasting economic damage rises.

It could come from one or other party attempting to break the impasse with a decisive escalation, or a gradual heightening of the geopolitical stakes. Talk of Finland and Sweden applying to join NATO, perhaps within weeks, would have been almost unthinkable at the beginning of the year—and it has been met with warnings of repercussions from Russia.

These geopolitical developments are likely to add impetus to the retreat from globalization, which appears to have stalled around the Great Financial Crisis before receiving a hard blow from the supply-chain disruptions of the COVID-19 pandemic. An important, 30-year tailwind behind non-inflationary corporate profitability and economic growth could be turning into a headwind.

As a result, the market has started to abandon the notion that the current inflationary episode is “transitory.” On the eve of the war, its estimate for the average U.S. inflation rate over five years, starting in five years’ time, was below 2%. Today it is 2.7%. The same market estimate for the Eurozone is also well above 2%.

Commodities

What might this mean for asset allocators?

First, it means that uncertainty remains high. The conflict itself could still deliver global shocks. Risks to growth are rising, but the world’s major economies currently look strong enough to withstand them. At the portfolio level, that makes a strong case for maintaining balance. In equities, we think that suggests a tilt to high-quality, lower-beta stocks across the board.

Second, it raises the prospect of especially high volatility—but also some long-awaited value—in fixed income markets.

Since the war broke out, core government bonds have suffered sustained price declines unseen since the beginning of 2009. But we believe the combination of rising yields, a resilient economy and robust corporate fundamentals is creating an opportunity in credit. Short-duration investment grade yields now stand at around 4% and non-investment grade yields over 6%—attractive levels, particularly if we are nearing a peak in rates volatility.

And finally, with oil up 36% year-to-date and wheat up 30%, but both down from their post-war peaks, investors may think the moment for commodities has passed. In contrast, we believe the prospect of a drawn-out conflict, with lasting geopolitical and economic fallout, reinforces the potential for an extended period of commodities outperformance and amplifies their importance for portfolio diversification.

With most major conflicts, the initial shock to markets soon gives way to economic fundamentals. But the invasion of Ukraine is already exacerbating current inflationary pressures, and it threatens to accelerate the retreat from globalization—the longer it goes on, the more it could affect fundamentals. In doing so, it could bend the arc of global economic trends for years to come.

Copyright © Neuberger Berman