Before the crisis, investors were focused on inflation trends in the context of slowing economic growth and concerns about monetary normalization.

From a global macroeconomic perspective, the geopolitical crisis primarily affects markets as a supply-side shock. This suggests that supply-side bottlenecks—which have been a major challenge since the COVID-19 pandemic—may persist even longer, with negative consequences and repercussions for growth prospects. The most significant and immediate impact will be on energy prices due to the heavy reliance on Russian gas supplies. For this reason, coupled with the potential supply-side spillover effects of possible additional sanctions against Russia, the inflationary environment is expected to worsen in the short term. Inflation has become a major political challenge in many countries, and it is likely that several governments will consider implementing measures to alleviate the impact on their citizens.

In this context, it is understood that the announcements of new U.S. sanctions against Russia—despite having been described as “devastating” by President Biden— specifically exempted Russian oil and gas sales, as well as exports of various other raw materials.

Biden himself added that he would do everything possible to protect American consumers from any adverse effects, which amounts to admitting that nothing would be done that could threaten Russia’s ability and willingness to continue supplying global energy markets. Officially, the U.S. and European governments have been saying that they might consider another round of “even tougher” sanctions. However, it is becoming difficult to imagine what additional actions Russia would need to take to provoke this “even tougher” response.

As of this writing, the markets are trading more steadily, and sentiment has improved after Russia described Ukraine’s offer of neutrality as a “positive development” and following reports that Chinese President Xi held a phone call with Putin, who said that Russia is willing to engage in high-level negotiations with Ukraine.

Beyond a possible “relief rally” in assets should geopolitical tensions ease somewhat, we believe that the potential for recovery will remain limited, because if it is not geopolitics, it will be concerns about inflation and monetary policy normalization—and a possible “policy mistake”—that will dominate the scene.

There is “a temptation” to conclude that rising geopolitical tensions will “deter” central banks—and, in particular, the Federal Reserve—from backing down from their plans for a faster normalization process.

At first glance, this makes sense. History shows that the combination of upside inflation risk and downside growth risk has mixed implications for monetary policy. Historically, Fed officials have sometimes preferred to delay major policy decisions until uncertainty surrounding geopolitical risks subsides. In some cases, such as after September 11 or during the U.S.-China trade war, the FOMC has cut the federal funds rate.

However, the current situation differs from past episodes, whengeopolitical events led the Fed to delay or ease its tightening, because the risk of inflation has created a stronger and more urgent reason for the Fed to tighten today than in past episodes. With short-term inflation expectations already high, further increases in commodity prices could be more concerning than usual. As a result, geopolitical risk is not expected to prevent the FOMC from consistently raising rates by 25 basis points at its upcoming meetings, although it is reasonable to expect that geopolitical uncertainty will further reduce the likelihood of a 50-basis-point hike in March.

According to Goldman Sachs estimates, a US$10/bbl increase in the price of oil pushes up U.S. core PCE inflation by 3.5 basis points and headline PCE inflation by 20 basis points, but reduces GDP growth by just under 0.1 percentage point. The blow to growth could be somewhat greater if geopolitical risks substantially tighten financial conditions and increase uncertainty for businesses.

Source: Goldman Sachs

Therefore, geopolitical tensions do matter, but the underlying problem facing markets today—and thus investment decisions—is inflation (a risk fueled by geopolitics, incidentally), and it must be addressed decisively. I would even go so far as to say… it is preferable for the Fed to take a firm stance in March rather than continue to be accommodative; contrary to common sense, this may be received much more favorably by the market, since there is nothing more damaging to business and consumer decisions than uncertainty surrounding inflation.

Any recommendations?

Increase exposure to commodities. The escalation of geopolitical tensions has significantly heightened the risk of further exacerbating the energy and commodities crisis that has unfolded over the past two years. Potential disruptions to trade in oil, gas, grains, and metals now pose a significant risk to investments and the real economy. Investors should therefore hedge against this risk by increasing their allocations to commodities, energy, and materials. These allocations would serve as a hedge against inflation and geopolitical risks.

Humberto Mora

Strategy and Investments