Financial markets have been hit by turmoil since the inception of Russia’s incursion into Ukraine. Stocks and Commodities have been experiencing volatility not seen since the inception of the Covid-19 pandemic in March 2020.
Some have labelled the current scenario as a ‘Black Swan' event that could potentially wreak havoc across the markets. With unprecedented uncertainty from market participants, what does the future hold for financial markets?
What is a Black Swan Event?
For those unfamiliar, a Black Swan is an unexpected phenomenon that goes beyond what is generally expected of a situation and can have big ramifications. Black Swan events were popularized by Finance Professor Nassim Nicholas Taleb.
Taleb coined the term after experiencing Lebanon’s civil war in his south. The conflict, which drew in Maronite Christians, Sunni Muslims, Shiites, Druze, and Syrians lasted fifteen years and resulted in the death of ninety thousand people.
Using 2008 as an example, Taleb described a Black Swan event as one that is impossible to predict ahead of time and can have far-reaching consequences across markets. Thus, Taleb argues that investors should factor in the probability of a Black Swan event taking place and plan.
The State of the Market
Market participants who were hoping for the recovery of the global economy after the end of the pandemic were in for a shock with Russia’s incursion into Ukraine.
The war between the two countries is at risk of spiraling out of control and bringing severe disruptions to the global economy. The largest economies in the world remain fragile, having seen disruptions across the supply chains over the last eighteen months as a result of the pandemic.
Looking back, Covid-19 induced lockdowns resulted in demand production being halted. Furthermore, stimulus checks and a favorable interest rate environment ensured large demand from cash infused households for products and services.
Asset prices soared as a result of the artificial boom, further inducing an image of wealth creation in the economy.
But this is when the cracks started to show up as well.
Fragile supply chains recovering from the pandemic ensured delays and disruptions, while also driving freight costs up. Similarly, in what came to be known as the ‘great resignation’, employees started leaving in droves, resulting in higher wages across industries.
Inflation is at a record high, commodity prices have been skyrocketing while ‘real’ growth appears to be muted. Markets began tumbling in November with a hawkish policy expected from the Fed this year (7 interest rate hikes anticipated), but the worst was yet to come.
Declaration of War
Russia’s invasion of Ukraine could have far-reaching consequences, not only in Europe but across the world.
Raw material prices have soared to multi-year highs as a result of the sanctions imposed by the US and Europe against Russia, and the incursion into Ukraine itself. Both countries make up nearly a quarter of the global wheat exports, with prices having risen 40% since the war began.
Furthermore, other commodities such as Corn & Sunflower Oil, and Precious Metals such as Palladium, Nickel and Aluminum have all seen large investments over the last two months, as investors continue to speculate on what happens next.
Perhaps the largest such disruption seen due to the conflict is of Oil. Moscow is one of the world's top oil exporters, with approximately 7.5 million barrels a day being exported.
Sanctions imposed by the US and its allies on Russia's banking system have already triggered a reaction against Russian oil from banks, purchasers, and transporters. Around two-thirds of Russian Oil is still struggling to find buyers, and crude prices could touch $185 per barrel (prices briefly touched $140 last week, before coming down due to China Lockdowns) by the end of the year if the situation isn’t resolved.
Black Swan or a Repeat of History?
The rise in commodity prices that has followed Russia's invasion of Ukraine draws an interesting connection between the 2020s and the 1970s.
The conflict in Eastern Europe has the potential to have an economic impact akin to the oil embargo of five decades ago. This implies that lowering inflation will be a slower and more painful process than policymakers had first anticipated.
The current scenario paints a resemblance to the macroeconomic conditions of the late 1960s and early 1970s. Back then, inflationary pressures were building through, primarily fueled by high government spending and rapidly rising wages.
Then, in 1973, OPEC banned the United States from exporting oil due to its participation in the Arab-Israeli war. Oil prices skyrocketed as a result. That's the type of price shock that central banks can't control. However, because it occurred at a time when inflationary psychology was already heightened, it contributed to the entrenchment of expectations of ever-rising prices.
Dealing with the Current Crisis
In the short term, market participants can expect a lot of volatility as long as the current crisis ensues.
Goldman Sachs anticipates that there is a 5-10% probability that the combined impact of foreign sanctions & military losses could force President Vladimir Putin to step down from his office.
Such an event could lead to a relief rally across stocks (between 10-15%), especially high growth tech stocks which have been depressed over the past month.
However, the most likely scenario is of a status quo, where continuing economic measures from the current sanctions cripple access to continue the incursion into Ukraine. This is expected to lead to increased inflation over the short term, especially across commodities such as Oil, Wheat and Corn, Metals such as Nickel (prices rose 90% last week and trading was halted briefly) and Palladium.
A final scenario that is unlikely, but probable (experts estimate it at 1%) is the end of the war through nuclear weapons. Such a scenario would wreak havoc across the globe and crush financial markets.
While the possibility of a Third World War remains slim, Putin has previously warned countries aiding Ukraine in the current conflict would face consequences never seen before.
While the current crisis in Ukraine may be a cause for concern, financial markets have generally brushed off geopolitical conflicts over the long run. A CFRA study, which looks back at the 20 major geopolitical events dating back to World War II, shows that stocks fully recovered losses within an average of 47 trading days after an average maximum drawdown of 5%.
Conclusion
The current crisis may seem like a ‘Black Swan’ event to many, but the situation resembles the conditions between the late 60s and early 70s. Markets have been reeling with inflation out of control, surging commodity prices led by oil and geopolitical uncertainty in Europe.
However, history shows that despite all the negativity in the short run, markets tend to bounce back up eventually.
Simply look at the S&P500 index over the long run, that says it all:
Hope this was useful for you! Please note that the above content is not an investment advise and shall be considered only for informative purpose.
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