Markets fear inflation more than war

“Investors who lived through the 1980s may be experiencing a sense of déjà vu – persistently high inflation and strained relations with Russia”, say Lauren Foster and Andrew Welsch in Barron’s. Yet the America’s S&P 500 is only marginally down since the Russian invasion last week. The FTSE 100 is off about 2%. Other European markets have been hit slightly harder, with Germany’s Dax down more than 5% since 23 February.

These fairly small moves may be because “history tells us that major geopolitical events will have almost no impact on markets after six to 12 months”, says Michael Rosen of Angeles Investments. “Looking at the past 70 years, markets have usually taken a few weeks from the start of a war to find a bottom,” says Stefan Kreuzkamp of DWS. “Once markets conclude that the (economic) situation is not going to deteriorate any further,” then asset prices start to rise again. That said, “a military conflict on this scale, in the backyard of the EU and involving a superpower, has not happened during the past 50 years” – so we don’t have much historical precedent to go on.

The Ukraine crisis “is not yet a markets crisis”, says Ethan Wu in the Financial Times. Assets “are priced for a medium-term disruption in certain sectors, but not yet a broader disaster”. The trouble is that the “tail risks” of the Ukraine war, such as the conflict spreading to other countries, are difficult to price. “In a year’s time, either this war will have changed little about markets, or changed everything.”

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A headache for central banks

Investors have so far focused on the inflationary implications of the war. Supply chains are taking another battering, say Alistair MacDonald and William Boston in The Wall Street Journal. “The fighting has shut down car factories in Germany that rely on components made in Ukraine and hit supplies for the steel industry as far as Japan.” Airspace closures will raise air freight costs from Europe to Asia. Financial sanctions will complicate how seaborne trade is conducted. All of this generates inflationary pressure.

Spiking commodity prices increase the odds of “stagflation”, says Roger Bootle in The Daily Telegraph. Higher energy and commodity prices simultaneously inflate consumer prices, while depressing demand by eroding consumers’ disposable income. Potential parallels from economic history are the oil shocks of 1973-1974 and 1979-1980. The lesson of the 1970s is that central banks need to act promptly to stop inflation becoming permanently embedded in the economy. Yet raising interest rates would worsen the hit to economic demand. Things have just got “much more difficult” for the Bank of England and its peers.

The current market consensus is that central banks will continue to hike rates as planned, but may do so at a slightly slower pace. Traders previously thought the Federal Reserve and Bank of England would probably raise rates by 0.5 percentage points this month. However, current market pricing shows that they now think a 0.25 percentage point hike is more likely.