Impact of Russia-Ukraine war on global markets

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MARKETS are likely to remain volatile, at least in the near term, as investors assess the consequences of Russia’s invasion of Ukraine. While we do not know how long this conflict will last and how far Russia will go, we expect harsh sanctions to be dealt on Russia as well as counter-sanctions against the West. A de-escalation and resolution in the near term are uncertain.

In the absence of a meaningful de-escalation, we expect commodity prices to remain at elevated levels, while further escalations will likely result in an energy price shock. The current sanctions have stopped short of targeting Russia’s energy exports but we believe this remains a possibility, albeit as a final resort. Should this happen, we see material risks for a sustained period of higher energy prices and possibly further tightening measures from global policymakers.

This latest development exceeds the severity of 2014’s Crimean crisis and has resulted in substantial economic uncertainty. We also expect risk sentiment to remain fragile due to the negative news flow, and while markets digest the impact of a rise in commodity prices and inflationary pressure. The flight to safe-haven assets is likely to continue in reaction to escalating tensions.

In our view, there are both direct and indirect impact arising from this ongoing crisis.

The most relevant direct impact will be on trade, as sanctions may potentially limit import and export from Russia to its trading partners. Among major economic regions, Europe has the largest trade links to Russia. Outside of Europe, there is very little direct trade between Russia and the Western developed world. As such, any direct impact will largely fall upon European economies. The US and Asian economies are relatively insulated.

The indirect economic impact will be in the form of higher inflation. Prior to the Russian-Ukraine crisis, commodity prices are already elevated from a historical perspective. A severe military escalation will not only drive prices higher but may also lead to a sustained period of elevated prices, as outlined above.

This has global economic implications as it puts further upward pressure on inflation – which is already at an elevated levels – thus leading to a potentially stronger policy tightening by global central banks. Considering the global macro backdrop, which is recovering from the recent Omicron growth drag, further policy tightening (to stem out inflationary pressure) will weigh on the global economic recovery.

We believe there is no need for investors to panic sell. In general, geopolitical crises are also hard to predict and price. History has shown that geopolitical military events tend to have a short-lived impact on markets. Furthermore, the fundamental backdrop remains firm for equities, with the Omicron risk gradually fading and global earnings still robust.

What is more important, however, is the indirect impact of inflation through higher energy and food prices, as Russia and Ukraine are two of the world’s largest grain exporters, and Russia is also a major energy exporter. A further escalation in this crisis could further push up commodity prices, adding more uncertainty to the global inflation outlook.

Instead of trimming exposure to equity markets at this point, investors should be strategically positioned for a trend of rising interest rates and tilting their portfolios towards part of the market that can outperform in such an environment. Specifically, we believe investors should consider doing the following:

i) Diversifying the portfolio. A diversified portfolio, especially across asset classes, may reduce volatility during this period. In our opinion, Asian markets have less direct economic exposure, geopolitical exposure and have relatively more accommodative policies. We recommend Asian ex-Japan equities for a diversified Asian exposure.

(ii) Commodity-related equities as a hedge. Commodity prices are likely to remain at elevated levels in this current environment, making commodity-related equities a decent hedge in the portfolio.

iii) A value tilt in equity exposure, as there are certain sectors that stand to benefit from a rising interest rate environment, such as global financials.

(iv) Reduce duration in fixed income exposure. This is to protect against the prospect for higher inflation, as well as a faster-than-expected rate hike environment arising from rising commodity prices.

Any market correction due to war impact fears could present a good opportunity for long term investors to accumulate equities as the global economic fundamentals remain intact. Markets reward long-term investors who are able to look past short-term noises.

This article is contributed by iFast Research Team.

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