Economic and Market Impacts of Russia Invasion

Stephen Dover: First, I want to very personally acknowledge the loss, grief, and uncertainty that's being faced by so many people in Ukraine at this moment. I feel this personally with my own personal history as an investor in emerging markets, having visited, Ukraine, as well as Russia, many times. So, we take this very seriously, but I also want to acknowledge that we're fiduciaries.

We're going to start with Kim Catechis. He has a history working in emerging markets and has a long history of working in Eastern Europe.

Kim, give us a perspective of how we should look at this over a longer period of time.

Kim Catechis: So, we're all aware of the history, since the Berlin wall came down, Russia, it was a much-diminished power and, you know, for a long time, I think we felt that things were fine. Vladmir Putin as leader of Russia came across as someone who is rational, low appetite for risk, until last week.

One of the most impressive things that I have seen, and certainly did not anticipate is the concerted series of sanctions movements. Not only because the sanctions have come thick and fast, but because they've come unified. Countries like Switzerland who have spent centuries being neutral, are no longer neutral. This has been a real wake up call. And I think, you know, certainly speaking to political analysts who are close to the Russian situation, they say that the leadership's been taken aback by that.

I think on one level, we've got to see this as a shock to GDP growth expectations. We've got to see it also as a shock to inflation expectations. It's coming at a particularly tough time for central bankers, because they're already, you could argue, on the back foot in terms of, depending on the country you're talking about, in terms of trying to get ahold of, get ahead of inflation expectations that they're dealing with. So, we may find that when push comes to shove, as you start to unpick these disconnections between the West and Russia, economic disconnections, I mean then I think what you might find is central banks will have to be a bit slower in terms of their previously agreed or expected calendar of rate rises.

The West is going to end up doing is, really cutting down the number of economic linkages that it has with Russia. And in the short term, the only thing really Russia has that can be weaponized is exports of oil and gas. And, as we all know, oil and gas is everywhere in the globe. So, the limitation factor here of that action is really down to how quickly can liquified natural gas be pushed through to Europe.

The situation there is that Europe already has enough capacity of liquified natural gas import terminals. The problem is that certain parts of Europe don't have enough access to them readily. So Germany, for example, doesn't have one. These are challenges that can be overcome by building additional pipeline capacity, et cetera.

And, I don't think that the sanctions are over by the way, I think they're going to continue ratcheting up as time goes on. So, I think this process could take time. The oil price is high level relative to recent history, but, you know, the, the futures market for delivery of Brent in December is suggesting that it goes down to 85, who knows, but, you know, there could be a short-term impact and a long-term one. The one that I find difficult to calculate, and perhaps my colleagues here will be able to help is what is the ultimate impact on the global economy? You can see Europe being affected short-term, what's the ultimate hit going to be in the global economy, Stephen?

Stephen Dover: Well, thank you very much, Kim. Let's now turn to Dr. Andreas Billmeier, European Economist for Western Asset Management. Andreas when we were talking yesterday, you described this situation as 40 years of policy kind of thrown out in four days. what do you mean by this? And, and can you kind of give us the European perspective of what's happening?

Andreas Billmeier: I think I said 40 because 40 is the average between 30 and 50, with 30 being roughly the fall of the Berlin wall and 50 being roughly the starting point of the German policy, Eastern policy as a concept. And by that, I really mean the relationship with Russia, first in sort of organizing systematizing the relationship with east and between Western and Eastern Germany, that then beyond that and beyond the, the fall of the wall to really how to behave relative to Russia, who is, you know, ultimately a very close neighbor. I think German foreign security, energy, policy, environmental policy has been based on having that stable relationship and largely friendly relationship with Russia for decades. And I think that went out the window in four days in the sense that all of this has been revised.

Stephen Dover: Well, I think it's remarkable how, how much Germany has changed, but maybe give us your perspective as both an economist and how this changes the map for investors as they look at particularly Europe, including Eastern Europe.

Andreas Billmeier: So I think purely from an economic perspective, you need to look at revising your forecasts, right? So, you need to look at a growth shock. If two months ago you're thinking Europe would grow by 4% this year, then, you know, it's clearly less than that. It's probably 3.5% going towards 3%, as hostilities continue. You need to think about new supply chain issues. European production has been outsourced to a number of countries including Ukraine. So, you already see the German car sector, complaining about different supply chain issues. So, growth is going to go down, inflation is going to go up, because of, the headline shock to energy prices. And, you know, as Kim just explained, I mean, this can get a lot worse from here, certainly in the, in the near-term.

Now, where does that leave us from a policy reaction? I think there's two things that I would be looking for. One is, at some point, the fiscal policy maker needs to say, enough is enough in the sense of, we need to protect purchasing power, real purchasing power of our citizens. So, you'll see experiments with capping energy prices would be my suspicion. We've seen that in smaller economies, but I think we'll see that in a broader sense. And in that context, you might also start looking into things along the lines of what we've just seen with the European recovery fund, the next generation EU, where the green transition that has been ongoing now needs to be substantially accelerated. And, not only does it need to be green, it also needs to do a whole bunch of other things to get Europe and Germany in particular, but also other countries off the Russian energy hook.

And then on the monetary side, maybe last thing to say is that it puts the ECB [European Central Bank], which, you know, central bank that hasn't been easy territory anyway, uh, in an even tighter spot because on the one hand headline inflation's going to go up because of energy price but core inflation typically in these standard textbook situations in many ways, actually goes down because of the hits to activity. Now, we're in a bit of a special situation because, I said before, we're looking at growth growing from 4- 3%. 4% is three times European potential and 3% is two times European potential. So, we're still growing way ahead of potential and so that standard response that core inflation is actually going down, I'm not so sure that we'll, we'll, we'll actually come to see that, but I think a lot here depends really on how long the hostilities continue and just how abrupt the switch of the energy provision or the energy sort of trades flow will be. And that's ultimately at this point a key issue for, for Europe, Germany in particular, but Europe also in broader terms,

Stephen Dover: Thank you, Andreas.

Let's turn now to the equity markets. We have Scott Glasser. Scott's the CIO of ClearBridge, Scott, if you just look statistically at past situations, where there's been a war or a big political event, the market's fallen and then there's been a pretty big recovery. I know you came into this market at the beginning of the year, really having some concerns, being neutral or even slightly negative on the market. What are your thoughts now?

Scott Glasser: I think that incrementally what's happened, leans me even more in the incrementally worried direction. My view has been and continues to be that for the last three years, in the US markets, we've seen outsized gains, you've seen approximately 25-26% annualized gains in the us market, despite COVID, due primarily to a flood of liquidity coming from monetary and fiscal stimulus. And those gains are unsustainable. And those gains would put the market actually in the 95th percentile of three-year annualized gains. And it was more than likely, as we moved forward, because of the shocks to the economic system from COVID, which resulted in supply issues, but also employment issues,  and goods inflation, and now service inflation and wage inflation, to the likes of which the US, and I think a lot of other parts of the world, haven't seen in, in, in literally 40 to 50 years since the seventies, that the Fed would be forced into a situation of removing liquidity from the system.

And that, in assessing bull and bear markets, I've always believed that liquidity is the most important factor. And therefore, we would be going from an excess liquidity position to a more normalized liquidity position, and that would have an effect on stocks and the market itself. And therefore, considering where we had come in terms of returns, I was arguing that as we make this adjustment back towards a more normal environment, that in fact, my position was kind of more neutral that the markets would have to adjust from a multiple standpoint to the new reality, which would be kind of back to the old reality. It's normal in markets that you could have a pause in returns. And so, you would have subpar returns for a period of time.

In the first quarter, we saw, that the earnings expectations were too high for a number of companies and while revenue and the US economy continues to be strong, clearly, the supply pressures and cost pressures and wage pressures are starting to have effects on earnings and earnings expectations. I do believe that that shorter term, US margins have peaked. It's not a revenue issue, it's an expense issue. We have started to see, earnings expectations revisions start to come down and this was before the invasion of Ukraine. I think those issues have been exacerbated to a certain extent, clearly the expense issues with the likelihood for weakness in Europe affecting US companies. So, it's not Russia itself. Russia's GDP is a little bit bigger than the economy of Spain. To put in perspective, about 50% of that is, is oil, but it is clearly the effect of the pressures on commodities, broadly based energy grains metals on Europe and then secondarily on the United States. And that brings into question, earnings expectations for the second half of the year.

When you add on top of that, the Fed probably goes slower and probably has to, because they're clearly behind the eight ball here and need to act but they probably go slower than they otherwise would have. China is probably more stimulative than we would've thought of, you know, a month ago. So those are, those are some positive, at least near-term offsets. Yet in the longer term, you still have to deal with the issue, you still have to kind of get back to a more normal liquidity environment.

Stephen Dover: Thank you, Scott. Let's turn now to Dr. Michael Hasenstab, Head of Templeton Global Macro. Michael, even prior to these events, your global view was that inflation would actually be a bit higher, for longer with some regional nuances. I'm just wondering, has that changed and, and how are you looking at inflation and growth at this point?

Michael Hasenstab: I think, as we think about how this ripples, through the world and, Stephen, your question  was on inflation, initial conditions matter. Initial conditions in terms of how parts of the world will be affected and react to this, um, how asset values will be affected if an asset was overvalued before a shock it's likely to adjust, if it was undervalued before a shock, it has a little bit more cushion. When we think about kind of parts of the world, say Asia, as we went into this, you know, was largely positioned, with stronger economic growth, with larger trade surpluses, going through a reopening phase, lower levels of debt, ex-Japan. So these shocks, you know, will obviously hit all parts that world. They probably are most dramatic in Europe, but have effects everywhere, but those initial conditions are important to evaluate as, as, as we think forward.

I think the geographic proximity also is very, very important as we evaluate things. The transmission mechanisms that we see of this are really about market liquidity. I think global central banks have a pretty good playbook from GFC, from COVID of providing market liquidity in periods of shock. So certainly, we see some of that happening, but I think we can have confidence that they have a good, good playbook there. And then it's really through the energy and food side, and this is what leads to the inflation question that will be most felt regionally, locally, but clearly if that persists for a longer period that is going to have knock on effects. And I think, you know, as we think through the US, it's also important to note on the inflation side, we weren't being hit just by energy prices. Really inflation was getting embedded in the labor market, in the housing market, in a lot of factors that were more permanent as opposed to one off. So, if you layer another shock on top of that, you know, it is obviously additive, but really the base was there. So I think inflation in the US is going to be a challenge. And, it is something that is going to put a very difficult decision on policy makers of how to react to the growth impulse, negative shock, while at the same time address  the inflation shock.

Stephen Dover: Michael, you've had some concerns and really mentioned that we have to look at wage inflation globally, I think, particular in the US, and you've also been quite constructive on opportunities, particularly within Asia. I'm just wondering what your perspective on those two issues are now, wage inflation, and also just your thoughts on opportunities generally, but in Asia.

Michael Hasenstab: Well, I think on the labor market, I mean, when we've looked throughout US history and looked cross country analysis in different parts of the world, the persistence of inflation is a big function of how embedded in the labor market it is. And, is it a one-off bonus or is it a permanent shift in higher inflation? I think the challenge—particularly, I'm speaking of the US more so than other parts of the world—is there's just a shortage of people. Immigration has been declining for a while and COVID really shut it off. A lot of early retirement, a lot of regional dislocation is people can't afford certain high-cost jurisdictions due to high property prices and rent prices following that. And so, it's not just, I think temporary, but it's a bit more of a structural issue in the US and that's going to take some time to address.

So I think that's what our concern is, that the source of inflation in the US is one that historically has been a little bit more permanent. Not to say it isn't manageable and, you know, I think some of the factors like solving the supply chain issues over the course of the year, you know, those type of one-off things can, can be dealt with. And I think there's some confidence there, but the labor side I think is an issue. Now that's not something we're seeing as much in other parts of the world. It is more, more specific to the US. And just, and going to, to Asia, I think one of the, the things that people are underestimating is the importance of reopening in Asia. You know, Asia was pretty conservative during the COVID period and a lot of strict shutdowns. And you know, those are still continuing in China, but outside of China, there's definitely been a move towards life with COVID and maybe it's because none of us have really had the opportunity to be traveling and see that part of the world. But I think it is important to recognize that if you have a live with COVID world in Asia, and you have that reopening and you have that reopening happening globally, where it creates demand, that's an important engine of domestic growth on top of export growth. And the other factor is, as I said earlier, initial conditions matter, there was a pretty strong commodity mini boom, going on before this and these events have exacerbated some of that. And so, you know, there are certainly some commodity exporters, in Asia that will probably benefit. And then there are commodity importers that will have some pressures. So, it'll have some bearing effects there, but I think in general, we see the Asian region, you know, pre this crisis was in a pretty strong spot, expected to grow faster than the rest of the world, even if we have to downshift those global growth numbers, it's still on a relative basis, I think is, is, is well positioned.

Stephen Dover: Let's turn back to the equity markets and to you Scott, Maybe give us your outlook from a sector perspective and anything that's changed in, in terms of where you either have concerns or you see opportunities.

Scott Glasser: Look, I think the US economy is strong and it will handle the adjustment. I think the Fed is in a tricky position, but it will handle the increase in rates and a decrease in liquidity. I think that investors should know and realize that strong economic growth, doesn't always make great markets. So economic growth versus stock market performance are sometimes opposite, particularly at inflection points I think it's pretty obvious—the market shares my concern about growth in the second half of the year.

You had a strong cyclical trade that was kind of propelling the market over the first month of the year. And you've seen a reversal in that with the invasion in Ukraine and you see it most significantly in the reaction of the banks where there is concern about credit, particularly the largest banks. I still think that the cyclical trade and the more value-oriented trade makes sense. I do think that there are other sectors that also contribute.

Technology tends to perform fairly well in inflationary environments. And so, yes, I lean cyclical. And I lean towards the value side. And yes, some of the extreme high multiple stocks might get hit. But the more consistent technology and growth-oriented stocks that could come through with their growth, could absorb the impact of the higher inflationary pressures and would absorb the impact also on their multiple and do fine and perform fine. So it's not either-or. Sometimes people think it's one or the other. So technology, you know, would be in the middle of the list in terms of performance during more inflationary times.

I do believe that in terms of what I've called the “value trade,” one can start to include some of the more defensive value stocks in that trade, as well. And so that would typically be the consumer stocks and the health care stocks. My preference is for the health care versus the consumer stocks. A lot of the consumer stocks do have a lot of exposure in Europe and are exposed to things like high grain costs, higher transportation costs, which will come out of this. And so I would probably add some defensive, primarily health care, into my basket of kind of preferred sectors.

Stephen Dover: Andreas, if we turn to you, how is all of this going to impact European energy policy? How are Europeans thinking about what they need to do both in the short term and even in the future, as they look at their energy policy and their energy security.

Andreas Billmeier: I would say it's a packet, and you know, it's not necessarily only driven by Europe's own decisions. So going back to what we said at the very beginning, you know, Russia might at some point just, you know, switch off the tap in retaliation for what has already happened or what might happen from here on out. So I, I think what we've seen, is a combination of things.

One, essentially accelerate the renewable rollout. That's a big thing. You need a lot of money for that and you need the money quickly. The other one is create more storage for gas, coal, keep those plants, coal plants of working for longer. And what we have not seen, interestingly enough, yet is a turnaround from the phasing out of nuclear energy in Germany. That's been a big political topic. So far, they haven't gone there. But, you know, in an extreme case, you can imagine that also being back on the table, if it's about having energy or not. So, the way to look at it is that we need to accelerate, getting off the Russian hook. I think only 3% or so of UK energy comes from, uh, Russian sources. So that's something that's easily substituted, whereas Germany is on the order of 40% plus.

Stephen Dover: Michael, what are your thoughts on kind of supply chain and commodities and how that might impact your thinking?

Michael Hasenstab: As I mentioned, you know, we were having a commodity boom that really should benefit many emerging markets or, you know, soft, hard energy commodity producers before, you know, these recent events. And certainly those have only added to it. So I think there was already a very nice terms of trade shock, positive shock to places in Latin America and Southeast Asia. And this probably just extends that a bit, but I wouldn't say, you know, it's just this recent factor it's been going on for some time. So I think the, the commodity trajectory is obviously a challenge for inflation, but is also a positive for a lot of commodity exporters. And if we think about, you know, how does one manage inflation risk, you know, currencies of countries that produce commodities, if commodities prove to be, some sort of inflation hedge could be something worth looking at.

Stephen Dover: Thank you for that, Michael, and I want to thank Scott, Michael, Andreas and Kim, for giving us some perspective on this.

Host:  And thank you for listening to this episode of Talking Markets with Franklin Templeton. If you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about anywhere else you get your podcasts. And we hope you’ll join us next time, when we uncover more insights from our on the ground investment professionals.