Select Investor Profilechevron

What type of investor are you?

Individual Investor
Institutional Investor
phone iconContact
pdf download icon

Geopolitical Crisis & Market Implications

panelImage

Executive Summary:

  • Russia is advancing quickly toward Ukraine’s capital and other major cities as peace negotiations are just beginning.
  • Market volatility has increased amid nascent liquidity strains and assets closely linked to Russia are underperforming significantly. 
  • Risk assets with fewer direct links to Russia and Ukraine are holding up well as the price for many commodities are increasing given the two countries’ substantial market shares. 
  • The U.S. and its major allies announced severe economic sanctions on Russia who have retaliated in kind.

While recognizing that the situation is fluid, and that it’s still too soon to draw definitive conclusions, below, Spenser Lerner, Managing Director & Head of Multi‐ Asset Solutions at Harbor Capital Advisors, Inc., outlines his initial thoughts on the implications of Russia’s invasion for markets.

Russia Invades Ukraine as Western Allies Ratchet Up Economic Sanctions

The response by the U.S. and its allies to Russia’s invasion of Ukraine, thus far, has entailed further economic sanctions, increased troop deployments to surrounding NATO countries, and direct weapons transfers including Germany’s decision to allow weapons exports to a conflict zone for the first time in decades. Western sanctions announced so far include:

  • Prohibiting transactions with Russia’s central bank and sovereign wealth fund, which will hamper Russia’s ability to access a significant portion of its $640 billion in foreign reserves that are custodied overseas or require international counterparties.
  • Asset freezes and removal of access to the interbank payment network SWIFT for much of Russia’s banking system. However, there is an exception for energy‐related payments, but it is unclear how those will work in practice at this point. 
  • Export controls on technology, resulting in an inability to maintain the country’s high‐tech infrastructure. 
  • Cancelling the certification of the Nord Stream 2 pipeline from Russia to Germany. 
  • Personal sanctions on President Putin, Foreign Minister Lavrov, and much of the country’s elite. 
  • Suspending trading and investment in sovereign debt issued after March 1st, as well as limiting financial institutions’ underwriting of private sector debt and equity transactions. 

Russia was initially spared the most draconian measures such as the SWIFT ban; however, recently, global leaders shifted in tone and recognized Putin’s intention to challenge the post‐Cold War order on the continent. The severity of economic sanctions led President Putin to escalate the situation both rhetorically, by placing Russia’s nuclear forces on high alert, and economically. On the latter, Russia closed its airspace to adversarial countries, which mirrored their own decisions, and suspended foreign currency transactions abroad, potentially imperiling all external debt payments.

Russia-Sensitive Assets Decline as Commodity Prices Increase Notably

Commodity markets saw major price swings as investors grappled with the implications of heightened geopolitical risk and both countries’ central role in several major commodities. Brent crude oil prices increased a few percent and broke $100/barrel. Natural gas futures in Europe increased materially given the region’s reliance on Russian supplies amid historically tight inventory levels. Corn and wheat prices were beneficiaries as well given Russia and Ukraine’s significant market share, and where a sustained conflict could exacerbate global food insecurity.

Share_of_Global_Commodity_Production.jpg

EU_Natural_Gas_Levels.jpg

Conflict Between Major Powers is Unlikely

The major assumption behind our asset allocation view is that Russia and NATO will not come in direct conflict and that the macroeconomic impact of Russia’s invasion will be limited despite the immense suffering of the Ukrainian people. Russia, outside of its critical role in energy markets, is not a significant contributor to the global economy, although its isolation will increase its dependence on China in the medium‐term. Furthermore, Russian authorities have spent the last few years girding itself for sanctions in anticipation of further tension and the country holds significant foreign exchange reserves to stabilize the domestic economy, although sanctions imposed on their central bank make it difficult to estimate how much of this stock is accessible. Europe remains reliant on Russia for energy imports at a time when global supplies are severely limited, so we think sanctions on Russian energy exports are unlikely.

We initially thought that the most likely outcome was Russia securing a pro‐Russian government in Ukraine; however, Ukraine’s fierce resistance and the Western response make a negotiated settlement appear more likely. Meanwhile, Western allies will accelerate their plans to decouple their economies from Russia, which should continue Russia’s secular economic decline. While the long‐term implications of a more adversarial relationship with Russia are difficult to predict and beyond our expertise, the most important thing for markets, beyond direct conflict with NATO, is whether the invasion significantly alters global energy markets given the already precarious supply picture. We expect volatility to persist so long as uncertainty about Russian’s intentions and the world’s response remain.

The Federal Reserve (Fed) Remains on Course to Hike Several Times

The Fed will embark on a series of rate hikes beginning with their March meeting given robust economic growth and elevated inflation. Russia’s invasion confirms the messaging from the core of the Federal Open Market Committee that a 50‐basis point rate hike is unlikely at the March meeting. We think the Committee will continue to hike at each of its subsequent meetings through September and begin balance sheet normalization absent a material slowdown to U.S. economic growth or tightening of financial conditions. Given the U.S.’s significant energy production, higher energy prices are unlikely to weigh on the economy at current levels. At the margin, the events in Ukraine will cause the Committee to be a little more cautious over the second half of this year. Furthermore, heightened geopolitical risks could weigh on both confidence and U.S. Treasury yields as investors seek more protection against downside risk.

The picture is more complicated for the European Central Bank (ECB) and the Bank of England (BoE), and their respective economies, given their reliance on Russian gas amid already elevated energy prices. The potential terms of trade shock of further energy price increases would force them to hike interest rates more aggressively at a time when real incomes are falling faster, weighing on economic growth. Our base case is that energy prices will continue to be driven more by fundamentals than geopolitics; however, Europe and the U.K. are most vulnerable if we are wrong. For emerging market economies, the impact of an extended conflict on asset performance depends on the country’s terms of trade and its proximity to the battlefield. Neighboring countries like Poland and Hungary will remain under pressure, while net exporters and countries in Asia and Latin America should be relatively insulated.

Impact on Earnings Limited if Energy Prices Remain Contained

We attempted to estimate how much rising oil prices, because of geopolitical tensions in Eastern Europe, could affect earnings estimates in the U.S. The answer is minimal, but not negligible. We use a rule of thumb that every $10/barrel increase in oil shaves off more than 0.10% of real GDP and more than 50 basis points of earnings growth. We view the likelihood of NATO implementing sanctions on Russian energy exports as very low, but if it happens, we think oil prices reach $120/barrel, which amounts to a more than $30/barrel increase since the beginning of the Russia/Ukraine crisis. A $30/barrel increase would reduce 2023 earnings per share (EPS) for the S&P 500 by 2.8%, by our estimates. If oil sits where it currently is, then we think earnings will likely come in for 2023 around more than $245‐$250/share.

EPS_Sensitivity.jpg

Source: Harbor Multi-Asset Solutions

Using our fair value framework which regresses fundamental drivers such as credit spreads, U.S. manufacturing PMI, and changes in the 10‐year yield on the S&P 500 PE multiple, we have lowered our PE estimate to more than 18.4x from 18.7x based on a lower year‐end PMI (52 instead of 54) due to higher oil prices. The risk is to the upside on our PMI estimate given that oil prices have not actually increased to $120/barrel.

S&P 500 Expected Return Estimates Through Year End

S&P_500_Expected_Return.jpg

We therefore use $238/share EPS (down from $245/share currently) and an 18.4x PE multiple for our bear case year end price target which implies +6.0% from current levels. Our base case estimate calls for +10% upside from current levels for the S&P 500. As a result, we are adding to equities based on recent weakness in the broader market.


The data and information noted above is based on hypothetical assumptions. It is for informational and illustrative purposes only. This material does not constitute investment advice and should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. The hypothetical estimates presented do not represent the results that any particular investor may actually attain. Actual performance results will differ, and may differ substantially, from the hypothetical estimated performance.

For more information, please access our website at www.harborcapital.com or contact us at 1‐866‐313‐5549.

Legal Notices & Disclosures

The views expressed herein are those of Harbor Capital Advisors, Inc. investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only. 

The S&P 500 Index is an unmanaged index generally representative of the U.S. market for large capitalization equities. This unmanaged index does not reflect fees and expenses and is not available for direct investment. 

Performance data shown represents past performance and is no guarantee of future results. 

Investing entails risks and there can be no assurance that any investment will achieve profits or avoid incurring losses. 

Harbor Capital Advisors, Inc.

Blue Background

Connect with us | LinkedIn Logo IconLinktree icon to podcast media links

Harbor Funds Distributors, Inc. is the Distributor of the Harbor Mutual Funds.
Foreside Fund Services, LLC is the Distributor of the Harbor ETFs.
FINRA Brokercheck logo in white color

Investing involves risk and the potential loss of capital.

Investors should carefully consider the investment objectives, risks, charges and expenses of a fund before investing. To obtain a summary prospectus or prospectus for this and other information, click here or call 800-422-1050. Read it carefully before investing.

All trademarks or product names mentioned herein are the property of their respective owners. Copyright © 2024 Harbor Capital Advisors, Inc. All rights reserved.