Equity market outlook: Is the Ukraine war distracting from the ‘main game’?

After significant volatility in the first two months of the year, it looked as though equities had finally hit the bear market period many had been expecting. But with war in the Ukraine changing market sentiments, it could still be a few months before investors see a full correction in equities, according to ClearView Chief Investment Officer (CIO) Justin McLaughlin.

Russia’s invasion of Ukraine in February 2022 shocked the world, and it has also created ripple effects in equity markets as investors switch their focus from trading through inflation to preparing their portfolios for an environment where supply of many commodities may be restricted.

However, as ClearView’s Justin McLaughlin explained in his most recent CIO Insights webinar, improvements in the Australian share market in particular may be short-lived.

“We would expect equities to be pretty weak, but with war cross-currents they’ve been stronger than expected – it appears people have decided Australian equities are a commodity play and bid them up relative to other markets,” Mr McLaughlin said.

“But the commodity Australia is most dependent on is iron ore, and in aggregate iron ore exports to China from Ukraine and Russia add up to around 2 per cent of total exports. So it seems people have made assumptions and bid up the Australian dollar and the equity market without doing analysis on what the actual impacts are.”

But the effect of the war on oil prices, while not specific to the local economy, could still have a strong impact on global markets by adding to the risk of a recession, Mr McLaughlin pointed out.

“Many recessions in the US and globally have been caused by run-ups in oil prices, it’s a big deal and the one commodity where Russia is a significant producer,” he said.

“One thing the war does is it gives us oil price shocks and likely increases the risk of a sharper slowdown and possibly a recession in some countries.”

“That’s the true risk we see coming out of the Ukraine war - are we going to keep sanctioning seven million barrels a day of Russian oil? If that happens, we run the risk of a sharper slowdown.”

This risk was heighted by the “fiscal cliff” created in many developed economies as government COVID restrictions came to an end and stimulus support was phased out, Mr McLaughlin explained.

“This oil price shock is taking place against the backdrop of an economy that was likely already going to slow down somewhat – there is a bit of a fiscal cliff taking place, and from this quarter onwards we might start to see risks of a slowdown in the US manifest themselves more,” he said.

“The Fed recently raised rates by 0.25% and they have indicated they will raise rates another 6 times, so for another six to nine months we can expect the Fed to increase rates every month or so. That’s likely going to be tough for the American consumer and share market.”

However, Mr McLaughlin said that locally, the economic risks of a rising rate cycle were likely less severe, with the Reserve Bank likely to be conscious of the dangers of hiking rates too quickly given the recent capital city property boom.

“The RBA is forecast to be one of the more aggressive central banks pushing rates up to 2% by mid-2023, but we think that’s unrealistic and the economy is likely too sensitive to interest rates to let that happen,” he said.
“Property values as a measure of income are likely at all-time highs. That usually comes with very big mortgages that have been written in the last 12 months that have a stretched mortgagee on the back of it and it would likely take little in the way of rate rises to push the economy down.”

Mr McLaughlin said the Fed’s aggressive stance on rate rises remained the most significant risk in markets at the moment, but that the noise around the Russian invasion and the flow-on impact to commodities was likely to delay a correction in equities.

“The war has really focused people’s minds on questions surrounding trade during a war and in my opinion, this has taken them away from the ‘main game’, which is the idea that inflation is at high levels and the Fed has no choice but to keep raising rates,” he said.

“We’re dealing with some unusual likely short-term currents which are changing market relationships. If the war hadn’t happened, we believe the Australian dollar would be under 70 cents and the market would be much weaker. It’s still going to happen, but we have this unusual period (likely three or four months) to get through in the meantime."