The writer is chief global equity strategist and head of macro research in Europe for Goldman Sachs
The Russian invasion of Ukraine has a significant humanitarian cost above all. There are, also, economic impacts and spillovers into financial markets. Increased uncertainty has, in particular, significantly raised the risk of European assets.
Together, this has worsened the growth and inflation mix. Largely as a result of higher energy prices, inflation expectations have been pushed up, while the growth outlook has been lowered.
All of this comes at a difficult time for investors and for policymakers: supply side bottlenecks and recovering demand from the Covid-led downturn had already pushed up inflation to levels not seen for many years.
Markets have had to absorb a major change in expectations about policy. As recently as last summer, for example, investors were expecting no interest rate rises by the Federal Reserve this year; now the market is pricing in close to seven consecutive increases and we expect a further four rises next year.
Multi-decade high inflation and low unemployment have been seen in the US and UK. This has already spurred the Bank of England to raise interest rates twice to 0.5 per cent, the first hike in back-to-back meetings since 2004. Even the eurozone, which has long struggled with deflationary pressures, is seeing upward pressure on prices, and this will be exacerbated by the conflict’s impact on energy prices.
The direct effects of the crisis on trade are likely to be small given that Russia and Ukraine account for about 2 per cent of global gross domestic product and trade.
The euro area exports about 1 per cent of GDP to Russia and Ukraine. Germany is slightly more exposed than Italy or France. The cross-border banking exposure to Russia is also small — the largest among western European countries is Austria with about 1.4 per cent of GDP in cross-border banking exposure to Russia/Ukraine/Belarus. The UK has the next highest exposure at about 0.6 per cent.
The implications for the commodity markets are much greater, as Russia produces 11 per cent of global oil and 17 per cent of global gas. Our economists estimate that a 20 per cent rise in the price of oil would boost global headline US inflation by nearly 0.25 percentage points, and it could be more, potentially with higher food prices.
Europe is the most impacted region and will probably face higher gas prices given the halt to Nord Stream 2. Commodity price risk remains skewed to the upside, with further escalation likely to send European natural gas, wheat, corn and oil prices higher from already elevated levels.
At the same time, a new focus on increasing defence spending and higher investments in alternative energy sources will increase government debt levels, already elevated as a result of the pandemic.
From a financial market perspective, the main impact is through greater uncertainty and the potential effects of higher inflation and slower growth. However, assets such as equities had already experienced a correction since the start of the year as concerns about higher interest rates reduced their valuations.
The European stock markets were the most heavily hit on the news of the invasion and are factoring in a slowdown in growth. Using our macro factor estimates for growth pricing across European assets, the market has priced in about 0.5 percentage points of a growth downgrade, towards the lower end of the range of our estimates under escalation scenarios.
In the short term the risks are high and market volatility is likely to stay elevated. But it should be emphasised that valuations are not very stretched and we continue to see longer term value in Europe shares. The falls have pushed their price/earnings ratio to about 13 times, below the long-term average.
In the UK, the FTSE 100 index trades at a price-earnings multiple of less than 12 and a dividend yield of nearly 4 per cent. While there are downside economic risks, nearly 20 per cent of UK index revenues are from the oil sector — which will benefit from higher prices.
The modest valuations are despite low real interest rates, a further reopening recovery and an expected sharp rise in fiscal spending this year. Earnings will be boosted by the increased spend on renewable energy and on defence.
For longer term investors, the reasonable valuation, particularly across European and UK equities, should provide support. We would expect moderate returns over a 12-month horizon.