Geopolitical Conflict Adds to Headwinds for Markets

Russia’s incursion into Ukraine is horrific, and it undoubtedly marks a historic moment in geopolitical balance, with as-yet undetermined total effects on global security, humanitarian needs, political alliances and economies.

Last week’s invasion touched off a de-risking episode in global financial markets, with stocks selling off and commodity prices surging in reaction to the news. Though markets rebounded on Friday, volatility will likely remain elevated, and both the political and economic situations are in flux.

At the same time, here in the U.S., bond markets are increasingly pricing the potential for stagflation, a scenario of higher inflation and lower economic growth. And the Fed—which recently has grown more hawkish in its plans to raise interest rates and unwind its balance sheet—will have to weigh the trade-off between inflation and growth amid escalated global tensions.

We don’t know if the conflict in Ukraine will create lasting or just momentary effects on the market. But we don’t believe now is the time for eager buyers to enter what might look like an oversold market.

In fact, we remain wary of three additional challenges that could be with us for a while and may not be fully appreciated by investors:

• Uncertainty and complexity of the Federal Reserve’s policy-tightening path: Near-term inflation expectations have risen recently, as energy prices could remain higher given Russia’s role as a major producer. Meanwhile, the overall U.S. economic outlook appears downbeat, with nominal yield curves at their flattest since the early days of the pandemic. Though some market participants assume the Fed will not tighten as aggressively because of the Ukraine conflict, we expect the Fed to stay the course, though it will likely prioritize supporting growth over fighting inflation. All this suggests that Fed policy execution has become only more complex.

• Potential weakening of demand for goods consumption: We also expect an eventual shift in consumer spending from goods to services; this should fuel a recovery in sectors such as travel, leisure, live entertainment and dining. But gains for services businesses may come at the expense of durable producers, which may face falling demand. Many companies that catered to the “stay at home” trends of the past couple of years benefited from an extraordinary pull-forward in demand. Investors will need to consider the likely give-back for such companies, including secular growers.

• Inflation's pressure on corporate profit margins: Many companies have asserted that they are sheltered from inflationary drags by strong pricing power. But this pricing power is likely unsustainable, and, if it is somehow maintained, would only contribute to further inflation. We are seeing mounting pressure on earnings forecasts, with negative first-quarter guidance rolling in from many companies; tech firms feature prominently among those muting expectations.
  

Given all these factors:

• We advise investors against jumping back into the market, even though recent declines have made valuations look more attractive. Investors should watch earnings-revision trends and bond-market dynamics to gain conviction around a buyable bottom.

• Consider recalibrating expectations and sticking with quality names with strong cash flow and earnings achievability that aren’t fully priced.

• Sectors including financials, energy, materials, consumer services and healthcare look ripe for stock-picking ideas, while the U.S. small-cap category and emerging markets appear to have strong longer-term valuation support.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Feb 28, 2022, “Refocus and Recalibrate.” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.