The return of geopolitical risk
E*TRADE Capital Management
Markets that for many months have been focused squarely on rising interest rates, inflation, and a pandemic saw further turmoil in February from a different type of risk factor—geopolitics.
With Russia's decision to invade Ukraine, a stock market that was already pulling back in January was subjected to additional volatility. And while conflicts like these take an unimaginable human toll, their implications for the markets tend to be short-lived. That said, they are unquestionably of great concern—they heighten uncertainty and can make it more difficult for investors to stay the course.
A big question now may be whether the fallout from recent events—including potentially spiraling energy prices—could change the Federal Reserve’s stance on interest rates as it embarks on a cycle of tightening monetary policy: Hike rates too aggressively and it risks tripping up the economic recovery, act too timidly and it could fail to contain the inflation it has pledged to fight.
Here’s a quick look at the market landscape as we head into the new month.
Despite the late-month volatility, US stocks held up better in February than they did in January, with the S&P 500 falling 3% and the Nasdaq Composite losing 3.3%. The market trimmed its losses in the last three days of the month, and small-cap stocks were especially strong—the Russell 2000 index ended the month with a gain:
Crude oil continued to push higher in February—US futures prices gained 11% and topped $100/barrel the day Russia invaded Ukraine—and energy was once again the top-performing US stock sector, and the only one with a positive return:
International stocks didn’t escape last month’s volatility, but developed markets fared better than emerging markets, while Latin America (+4.8%), the Pacific (+2.8%), and the UK (+0.8%) were regional bright spots. The MSCI EAFE Index of developed markets fell 1.8%, while the MSCI Emerging Markets Index lost 3%:
Bonds mostly declined in February as yields, which move inversely to prices, continued to rise—more so in shorter-term maturities than longer-term ones. Along with Treasury Inflation-Protected Securities (TIPS), short-term Treasuries were one of the few areas of the fixed-income market that managed to with a positive return last month. The benchmark 10-year T-note yield topped 2% in February for the first time since July 2019, but ended the month at 1.84% as investors as “safe-haven” buying pushed up prices and pushed down yields as the conflict in Ukraine intensified:
As we noted last month, we’re moving away from an era of highly accommodative conditions for investors, and the market environment is likely to remain challenging—for reasons that were already evident before the Russia–Ukraine story dominated headlines.
- Geopolitical risk is real, but the shocks are often temporary. As the past several days have illustrated, market setbacks triggered by geopolitical surprises are often violent, but short-lived. (The market’s reaction to Russia’s 2014 annexation of the Crimean Peninsula from Ukraine is another example.) As the shock fades, the themes that were previously driving market activity typically come back to the fore.
- Fed returning to center stage? The markets still face the challenges of rising interest rates, inflation, and (as Morgan Stanley analysts have noted) potentially slowing growth.1 If not for the Russian invasion, many investors would likely be spending their time pondering the Fed’s March 15-16 policy meeting. Aggressive tightening may not be the foregone conclusion many people thought it was just a few weeks ago.
- Check risk. International investments may remain attractive from a valuation perspective, but last month also highlighted their risks. Investors concerned about the Russian invasion could consider domestic small caps (despite their volatility relative to large caps) in addition to value stocks.
Finally, although taking stock of your market exposure is never a bad idea, one of the biggest potential risks of a market shock is that it can trigger a loss of discipline and distract investors from their longer-term goals. The reason a balanced, diversified portfolio is such a powerful tool is that it is one of the best antidotes for the type of volatility and uncertainty we’ve witnessed recently.
Thanks for reading, and we’ll talk to you again next month.
Head of Portfolio Construction for Morgan Stanley Portfolio Solutions
Mike Loewengart is Head of Portfolio Construction for Morgan Stanley Portfolio Solutions and a Managing Director in the Morgan Stanley Wealth Management Global Investment Office. Mike is responsible for the asset allocation and investment vehicle selections used in E*TRADE’s advisory platforms. Prior to joining E*TRADE in 2007, Mike was the Director of Investment Management for a large multinational asset management company, where he oversaw corporate pension plan assets. Early in his career, Mike was a research analyst focusing on investment manager due diligence for the consulting divisions of several high-profile investment firms. Mike holds series 7, 24, and 66 designations, as well as the Chartered Alternative Investment Analyst (CAIA) designation. He is a graduate of Middlebury College with a degree in economics.
Executive Director, Morgan Stanley WM Global Investment Office
Andrew Cohen is an Executive Director in the Morgan Stanley Wealth Management Global Investment Office and an investment strategist for ETCM LLC. Prior to joining E*TRADE, he was the Director of Investments and Operations for a large Registered Investment Advisor, where his responsibilities included investment manager research, asset allocation, and portfolio construction. Previously, he was a Senior Research Analyst and Team Leader for a leading wealth management platform. He is a Chartered Financial Analyst (CFA®) charterholder and a member of the CFA Institute and CFA Society New York. He is a graduate of Virginia Tech with a Bachelor of Science (B.S.) in finance.