Prior to the crisis, investors were focused on inflation dynamics amid slowing economic growth and concerns about monetary normalization.

From a global macroeconomic perspective, the geopolitical crisis mainly affects markets as a supply-side shock. This suggests that supply-side bottlenecks, which had been a major challenge since the Covid-19 pandemic, may persist even further, with negative results and repercussions on growth prospects. The most significant and immediate impact will be on energy prices due to heavy dependence on Russian gas supplies. For this reason, coupled with the potential supply side spillovers of potential 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 several governments are likely to consider implementing measures to alleviate the impact on their citizens.

In this context, it is understood that the announcements of new sanctions by the US against Russia, beyond being described as "crushing" by President Biden, specifically exempted Russian oil and gas sales, and exports of several other raw materials.

Biden himself added that he would do everything possible to protect US 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 US and European governments have been saying that they could consider another round of "even tougher" sanctions. However, it is becoming difficult to imagine what additional actions would be necessary on Russia's part to provoke this "even tougher" response.

At the time of writing, markets are trading more steadily and sentiment has been boosted after Russia said Ukraine's offer of neutrality was a "positive development" and following reports that Chinese President Xi held a phone call with Putin, who said Russia is willing to hold high-level talks with Ukraine.

Beyond a possible "relief rally" in assets if geopolitical tensions ease marginally, 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 error" that will dominate the scene.

There is a "temptation" to conclude that increased geopolitical tensions will "deter" central banks, and in particular the Federal Reserve, from backing down on their intentions for a faster normalization process.

In principle, 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 funds rate.

However, the current situation differs from past episodes, whengeopolitical events led the Fed to delay tightening or ease policy, 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 steadily 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 increase in March.

According to estimates by Goldman Sachs, a US$10/bbl increase in the price of oil boosts US core PCE inflation by 3.5 bp and headline PCE inflation by 20 bp, but reduces GDP growth by just under 0.1 bp. The blow to growth could be somewhat greater if geopolitical risk substantially tightens financial conditions and increases uncertainty for businesses.

Source: Goldman Sachs

Therefore, geopolitical tensions do matter, but the underlying problem facing markets today, and therefore investment decisions, is inflation (a risk that is exacerbated by geopolitics, incidentally), and it must be tackled decisively. I would even go so far as to say that it is preferable for the Fed to take a firm stance in March than to continue to be complacent. Contrary to common sense, this may be much better received by the market, as there is nothing more damaging to business and consumer decisions than uncertainty surrounding inflation.

Any recommendations?

Add exposure to commodities. Geopolitical escalation has significantly increased the risk of further aggravating the energy and commodity crisis that has developed 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 this risk by increasing allocations to commodities, energy, and materials. These allocations would serve as a hedge against inflation and geopolitical risks.

Humberto Mora

Strategy and Investments