Geopolitical tensions hit markets – Episode 140 of Damien’s Midweek Markets

The 140th episode of my weekly YouTube show where I discuss what is happening in investment markets and what to look out for. This week I talk about how geopolitical tension is impacting markets.

Each show lasts between 5-10 minutes and is aimed at DIY investors (including novices) seeking contemporary analysis to help them understand how investment markets work.

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Abridged transcript - Midweek Markets episode 140

Coming into 2022 there were a number of potential market risks which I highlighted in my 80-20 Investor newsletter and in the weekly Money to the Masses podcast. These included rising inflation, central bank tightening and even the potential for the bond market to start pricing in a recession. While a number of these risks have indeed been influencing bond and equity markets so far in 2022, I also wrote how politics had taken a backseat during 2021, but how in 2022 politics and geopolitics were likely to garner more attention. And to that end, I highlighted the potential for an escalation of tensions between the US and Russia over the latter's apparent military preparations on the border with Ukraine

As you know from my recent shows the market has been preoccupied with the path of inflation globally and the responses from respective central banks. But this week the situation on the border of Ukraine took centre stage and was pretty much the only thing driving markets, be they bond, equity or commodities.

Heading into the end of last week equity markets were on a knife-edge looking for direction. Meanwhile, bond markets were showing signs of stress, with rising yields and widening spreads (which is something I explained to newsletter subscribers of my 80-20 Investor service). Memories of the eurozone debt crisis worried European bond investors. Meanwhile, the 10 year US treasury yield broke above 2% as investors began betting that the US Federal Reserve (the Fed) would make an emergency interest rate hike on Monday (which it didn’t) following robust economic data last week. We saw the usual equity market reaction, rising energy and financial stock prices while technological stocks lead the broader indices lower.

But ultimately the situation and expectation of a Russian invasion in Ukraine shook market sentiment as the week drew to a close. The result was that we initially saw a flight to haven assets. So for example government bond yields fell as investors ditched equities in favour of fixed income. The 10 year US treasury yield dropped back below 2%. We saw similar moves across other government debt markets.

Equity markets tumbled coming into this week. With the tech-heavy Nasdaq 100 down over 5% between last Thursday and the close of play on Monday. The S&P 500 was down 4% while European equities fell 2.5%. But as has been the story for much of 2022, the FTSE 100 outperformed, albeit with a fall of 1.46%.

But there is now an interesting dynamic in markets as investors try and make sense of the situation in Ukraine alongside rising inflation and central banks’ policy responses. It means that the trends we’ve seen already in 2022 now have an overlay of a “war trade” thrown into the mix. Bond yields have fallen (as investors seek haven assets) whenever negative headlines emerge regarding the situation in Ukraine. The opposite is true when diplomacy seems to be making headway. Energy stocks and commodities such as oil and natural gas have tended to outperform given Russia’s position as a key player in European energy markets. At the same time, the inflation backdrop has investors shunning technology stocks, particularly in the US, favouring sectors that traditionally perform better in a high rate environment such as financials.

The question that investors are also trying to answer is whether an invasion of Ukraine, which will likely accelerate energy price rising and inflation, will provide a negative shock on economic growth in Europe and beyond, so causing central banks to hold back on aggressive rate hikes?

All of these questions and potential market-moving events have ultimately brought one asset back in from the cold as its price has surged. That asset is gold. Gold hasn’t been a particularly good inflation hedge but geopolitical tensions, falling bond and equity prices (along with that fear of inflation) have created something of a perfect storm for the precious metal. We’ve seen its price attempt a breakout and it is now testing the $1,900 per ounce level. A break above there could open the door to more upside. Those who have gold in their portfolio, which includes my own £50k portfolio which I run on 80-20 Investor, may finally benefit from its lack of correlation to other assets in this environment.

Just as I finish making this episode news has just broken that the US President has indicated that there is a very high risk that Russia will invade Ukraine in the next several days. Equity markets have responded by falling between 1-2% today, following a rebound yesterday. What happens next in equity, bond and commodity markets will depend on what happens with the diplomatic efforts to avoid a war in Ukraine. Beyond that investors will try and work out how this impacts inflation and central bank policy responses around the world. Not an easy task.

It all means that equity markets (including the FTSE 100) have fallen into negative territory for the month of February. Equity market rallies continue being sold into right now. But unusually the situation is the same for bond investors too. It means it’s a difficult market for investors right now and everyone is looking for a catalyst to make that change.