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Brian Levitt & Paul Jackson | February 24, 2022

Perspectives on the Russia-Ukraine crisis

As Russian military operations began to unfold in Ukraine this morning, Global Market Strategist Brian Levitt spoke with Paul Jackson about the current market reaction and his thoughts on asset allocation in this environment. Paul is Invesco’s Global Head of Asset Allocation Research.

Brian Levitt:

Paul, let’s start with your initial reaction to the events that are unfolding in Ukraine. You have a great lens of history. I’d love for you to put this into some type of perspective for us.

Paul Jackson:

First of all, the markets are reacting as you might imagine. It’s a troubling situation. Uncertainty is never good, so it’s not surprising to see stocks down, gold up, bond yields down.

But I think when you look back over time at some big conflicts that we’ve had from World War I through World War II, and then more recent conflicts, it’s interesting to see that stock markets, and if I look at the U.S. stock market, for example, the downside isn’t as great as you would imagine.

We’ve already had quite a bit of downside this year, so I’m hopeful that we may have already seen quite a bit of the downside that is going to come from this.

Brian Levitt:

You talked about the market not liking uncertainty. When you look at the market, do you get a sense of how much of this uncertainty is already priced in?

Paul Jackson:

I think we can see that already so far this year that the price of gold, for example, has held up extremely well despite the rise in bond yields. Normally, rising bond yields would pull down the price of gold, but I think this geopolitical risk is one of the reasons why gold has been doing so well. I think there is a fair degree of uncertainty that is already priced in there. Normally, my model would say that gold should be probably $200 to $300 lower than it is today. I think that that’s a measure of the uncertainty that is priced in there, and the rise in the price of oil — we’re back above $100 per barrel now.

Brian Levitt:

So I want to hit on that point on the price of oil. When you think about what’s going on in the commodities market with oil over $100, everybody getting hit at the gasoline pump, it feels like this is the last thing that the world needed, and we were already grappling with inflationary pressures. Do you have concerns that this time may be different?

Paul Jackson:

Yes, and I think that there are a lot of things that are different about this cycle. The fact, for example, that U.S. unemployment is so low, at a point that we think is very early in the cycle, and before the U.S. Federal Reserve (Fed) has even started tightening. That is very unusual, and I think is one of the reasons why U.S. wage inflation is already higher.

Yes, absolutely right, about the rise in the oil price, which you would normally see through an economic upswing, but the extra kicker that has been given by this Russia-Ukraine situation is going to push inflation higher than it would’ve been and is clearly already squeezing household incomes.

Brian Levitt:

They started to suffer, right, so we think about it in the aggregate, and the narrative for this year has been heightened inflation, policymakers around the world behind the curve, moving to tighten pretty significantly. At least when you think about it from the Federal Reserve’s perspective, the idea is to begin to tighten financial conditions pretty meaningfully.

Now, does an event like this already start to accomplish some of that for them when you see an ever-flatter yield curve, you see credit spreads heightened, you see equity valuations down? Does this start to do some of that work for them, and should investors start to change their thinking? If they’re of the idea not to fight the Fed, does it change the Fed’s approach over the course of the year?

Paul Jackson:

Yeah, I think it changes the calculus of the Fed and for other central banks. This rise in inflation in some ways is self-defeating because it’s weakening the economy through the squeeze on real incomes and the squeeze on profits. A Federal Reserve that was starting to sound very hawkish, and market participants that were bidding against each other in terms of how many times the Fed would raise rates this year, I think that those anticipations are being dialed back.

The Fed itself, when it meets in March, it’s clearly not going to be looking at a 50 basis point rate hike, and they’re probably going to be debating, actually, should we still go ahead with any rate hike, given the uncertainties that are out there.

I think major central banks will now be more reticent to tighten. They may feel they don’t have to do as much, but also they don’t want to add fuel to the fire of the uncertainty that is out there.

Brian Levitt:

Of course, our view and our focus is first and foremost on the humanitarian side. But, as I listen to you speak, is there a paradox in that? We talk about how concerned investors were about tighter policy. Is this a return of a Fed put? Is this an all-clear sign? Is it a paradox that it creates a better all-clear sign for markets?

Paul Jackson:

I think it could help. I think we’re certainly getting a more rapid flushing out of markets, and a flushing out of the fever that had gotten into markets last year. To the extent that that has been accelerated, that may help. Yes, if it is staying the hands of the Fed, then equally it may help. Look back to 2020, would the S&P 500 have done as well during 2020 if it hadn’t been for the pandemic? A bizarre question to ask, but all of the support that was given by central banks and by governments really did help markets. We’re not in the same situation now, but I think you’re right. I think this ironically, at the end of the day, could help markets to find their feet.

Brian Levitt:

Now, Paul, I know your focus is on asset allocation. Would it be all right for me to ask you about the different scenarios in terms of how this plays out on the ground? Is that within your wheelhouse?

Paul Jackson:

You can always ask, and I’ll try to answer. I think that there are a number of ways that this can possibly happen. I can think of four scenarios, two of which I think are realistic.

At the very good extreme, you have Vladimir Putin decide that he’s made a mistake and withdraws. I don’t think that’s going to happen.

At the other extreme, you have this turn into something that involves NATO in conflict with Russia, and I don’t think that that’s going to be happening.

You have the two scenarios in the middle, which is that we stay with the situation that we woke up to today — that we have some strikes against military facilities in Ukraine, but not a full-blown invasion. I think if that turns out to be the case, then I think the markets have priced in all of that, and I would expect a reasonably rapid rebound in equity markets. I would expect gold to come down and bond yields to go back up.

On the other hand, the other likely possible scenario is that it actually does turn into a full-scale invasion, but without NATO getting involved. I think that that would just ramp up a little bit more of the uncertainty. You may see a further tendency towards what we’ve seen over the last few days, with stock prices going a bit lower, oil going a bit higher, and gold also probably going a bit higher. It really comes down to what Vladimir Putin decides here. It could turn around very quickly for the markets, it could be a bit more prolonged, but I think there’s a lot of bad news priced in there already.

Brian Levitt:

That last scenario sounds particularly frightening, but would you view it as a type of regional event that does not bring down a global economy, doesn’t end an economic cycle, similar to some of those events that you highlighted in the past?

Paul Jackson:

Yes, I think it would be regional in that scenario. Clearly, it’s more important for Europe, because Europe gets a lot of its energy from that region of the world. But, globally, I think the economic impact would come through the rise in the price of energy, rising inflation, and the squeeze on real incomes. But I don’t think it would be fatal for the global economic cycle.

Brian Levitt:

I’ll take it back to somewhere you’re a little bit more comfortable with than providing us the different military scenarios. What’s your view from an asset allocation perspective? How should investors navigate this, and how do you think they should be positioned for what it sounds like you believe will be a cycle that still has some time to run?

Paul Jackson:

Brian, I don’t mind answering military questions. I am actually in the British military. I’m a major in the British Army, so ask away — I’m in the reserve army, I should say.

But, when it comes to asset allocation, I always like to take a longer-term view. I think trying to navigate these short-term movements is very difficult. From here, given what we have seen over recent weeks and over the last couple of months, I’m still very much of the opinion that we should be favouring cyclical assets. I don’t think the economic cycle is threatened. I think it is slowing down, but I don’t think it is threatened.

Given that bond yields have come down again, I think that government debt is unattractive, so I would certainly prefer cyclical assets, things such as real estate. Not so much commodities now because they are way up there. But I think real estate and equities. I certainly would not favour government bonds, and within the fixed income space would look more favourably upon high yield and also investment grade more favourably than government debt.

Cash, I always use as the great diversifier, and I think it has proved its value. But, at some point when you get the VIX index, for example, rising close to 40 today, those I think are usually occasions when I personally would start to look to deploy those cash reserves.

Brian Levitt:

Paul Jackson, thank you very much, appreciate you joining us on such short notice.

Paul Jackson:

Thanks, Brian.

More from Brian Levitt & Paul Jackson

Perspectives on the Russia-Ukraine crisis
February 24, 2022

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