U.S. stocks rallied after Russia invaded Ukraine on Thursday. The news that the initial sanctions wouldn’t target Russian energy exports to Europe reduced concerns about a European economic slowdown. While global markets declined last week, the U.S. finished higher even though the S&P 500 moved by more than 1% on all four trading days.
Key Points for the Week
- Markets rallied from post-Ukraine-invasion lows on news the initial sanctions against Russia were less severe than expected and didn’t target Russian energy exports to Europe.
- Core PCE inflation rose 0.5%, confirming inflation remains a challenge for the U.S. economy.
- Strong fourth quarter earnings and a decline in stocks have pushed valuations lower.
U.S. economic news continued to affirm a trend toward higher inflation and robust spending. PCE inflation rose 0.6% in January, and core inflation, which excluded food and energy, jumped 0.5% (Figure 1). Strong demand in the goods sector remains a source of inflation. Goods inflation rose 1%, and goods consumption leapt 5.2%. Services spending rose 0.5%.
Other economic data suggested the U.S. economic recovery remains healthy. Manufacturing and services PMIs increased, showing more firms are expanding. Home sales slowed even though the number of homes sold that are not yet under construction jumped higher. Business investment remained strong, growing 0.9%. That is positive news because investment in new technology is a tool to fight inflation.
The S&P 500 recovered 0.8% last week. The MSCI ACWI declined 0.6%. International markets, especially Europe, are more vulnerable to economic and geopolitical fallout from Russia’s invasion of Ukraine. The Bloomberg U.S. Aggregate Bond Index shed another 0.3%, with losses concentrated in the corporate bond market. The ongoing conflict in Ukraine will likely capture most of the attention this week, along with Friday’s update of the U.S. employment situation.
A Powerful Lesson in How Markets Work
On the day Russia invaded Ukraine, U.S. stocks started out sharply lower as the breadth of the invasion was on the high side of expectations. Then, by mid-day, the S&P 500 turned sharply higher and rallied 1.5%. On Friday the S&P 500 jumped another 2.2%. For those unfamiliar with how markets work, it might seem like the market was responding positively to an unprovoked act of aggression that will cost many lives.
That isn’t the case. Instead, markets are functioning much as they should. Markets look forward and gauge the probability of events. In this case, the decline the previous week and the first two days of last week reflected market expectations that an invasion would take place. Once an invasion was reflected in market prices, the market moved on to additional factors.
The additional factors can be broken into three groups:
- Adverse economic consequences of sanctions
- Risks of escalation
- Long-term consequences
The initial decline on Thursday reflected the impression that the attack’s objective is to take over the whole country. Some believed Putin would only focus on the eastern part of Ukraine, which has a higher percentage of Russian speakers. But a more aggressive attack suggested more severe sanctions were likely.
Instead, Europe and the U.S. introduced tough sanctions that will challenge the Russians, but importantly exclude existing energy imports from Russia. That means Russia is likely to continue to export oil and natural gas to Europe. When it comes to market impact, how the conflict affects Western Europe is the top concern. Developed nations in Western Europe make up 17.2% of the MSCI ACWI. Countries that border Ukraine are only 0.6% of the same index, and that data includes Russia and was calculated prior to the Russian stock market’s decline this year.
The second factor is the likelihood of the conflict escalating beyond Ukraine. There is news some European countries may provide planes to Ukraine to support its air force. Sanctions tightened over the weekend, targeting the Russian central bank and some Russian banks’ access to the Swift global payment system that facilitates cross-border transfers. In response, Putin announced he had placed Russia’s nuclear forces on higher alert. The longer the conflict lasts the more likely the market will experience big swings from changing expectations on the risk of escalation. A small increase in the odds of a dangerous outcome could push markets lower.
The region’s long-term stability, which is our third factor, would be enhanced by a more stable Russia that is less likely to be aggressive to its neighbors. It also is promoted by a more united NATO willing to confront any ongoing Russian threat. Germany’s announcement it would increase military spending above 2% of GDP implies a greater commitment to military deterrence.
The unprovoked attack on Ukraine is a human tragedy. Its portfolio impact is much smaller because Ukraine doesn’t play a key role in the global economy. The biggest challenge is sizing up how this affects Europe’s recovery and how likely the conflict is to escalate beyond Ukraine. The sanctions announced over the weekend may be helpful in pressuring Russia. They may also raise the risks Russia will escalate the conflict in response to European nations providing more aid.
Trying to guess how markets will react to challenges can be very difficult. Predicting what will happen isn’t enough. It requires understanding existing market expectations, predicting how other players will react to events, and sorting out how other investors may respond. A more productive approach is to stay focused on your long-term plan and recognize that bearing risk is often the source of long-term returns.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
S&P 500 INDEX
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
MSCI ACWI INDEX
The MSCI ACWI captures large- and mid-cap representation across 23 developed markets (DM) and 23 emerging markets (EM) countries*. With 2,480 constituents, the index covers approximately 85% of the global investable equity opportunity set.
Bloomberg U.S. Aggregate Bond Index
The Bloomberg U.S. Aggregate Bond Index is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
MSCI Europe Index
The MSCI Europe Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe*. With 429 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe.
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Market Commentary: U.S. Markets Rally But Face Uncertainty Amid Russia-Ukraine Conflict