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Here are some key takeaways from last week and on the Russia/Ukraine conflict and its impact on the economy and the markets
Historically, Geopolitical Events Have Been Short- lived
Going back to World War II, the median market sell-off has been 5.7% after a geopolitical shock. On average, it has taken three weeks for the market to reach a bottom and another three weeks for it to recover those losses. Ultimately, the market isn't driven by geopolitical events, but by the economic landscape. Given the robust economic backdrop, the fallout specifically from this situation should be relatively short lived with the markets keying in on Fed policy and interest rates in order to dictate medium-term momentum.
U.S. Economy Remains Robust
The US economy is re-accelerating post-Omicron. While the invasion of Ukraine poses a minor headwind to growth, forward momentum is robust (GDP Now is 0.3% which is impressive considering January headwind - and should continue to strengthen as recent releases have strong: IP, retail sales, and business inventories). Importantly, the equity market's YTD decline is explained by a contraction in P/E multiples as 2022 EPS estimates have risen by 2%. Earning are well supported with nominal GDP likely approaching 10% this quarter.
Impact on Fed Policy Probably Negligible
The Fed has fulfilled its employment mandate (unemployment is 4%) and is focusing its entire attention on inflation. With inflation risks skewed to the upside, the Fed will likely not deviate materially from the market's pricing of rate hikes from this situation. At present, the market is pricing in 5.9 hikes from 2022 (down from 6.4 hikes). While we've been more inclined to see a more dovish Fed than the market is pricing, we continue to believe that the Fed will slightly undershoot expectation. Importantly, the Fed puts more weight into Core inflation rather than Headline because food and energy tend to mean revert and Fed policy acts with lag. Put differently, higher materials/ energy costs should not sway the Fed in a "material" way as the effects from tighter monetary policy generally kicks in when food/energy prices are deflating. The Russian invasion of Ukraine may create a more dovish rate scenario, in particular with the ECB. We will get further clarity form Fed Chairman Powell when the speaks to congress next week.
Core Inflation Not Likely to Rise Significantly Due to This Situation
Risk-off sentiment and uncertainty should be a bid under the dollar which historically has had a negative correlation with CPI.
-Continued supply chain issues
-Goods and material flow out of Ukraine and Russia will be halted and could exacerbate the supply chain issues many companies are facing (example: steel for autos).
-Natural gas and oil price spikes will have a material effect on US headline and minor impact on core inflation.
- Pricing pressures should remain sticky here due to potential supply disruptions, precautionary hoarding, and an embedded geopolitical premium.