Stock Market’s ‘Denial Trade’ on Russian Invasion Is Buckling

(Bloomberg) -- Equity markets have come round to the idea that Russia's invasion of Ukraine could have long-term consequences for the global economy. 

European stocks slumped at the end of the week and are at the lowest in a year as the sweeping measures slapped on Russia disrupt trade with one of the world's main suppliers of key commodities, especially energy. 

U.S. stocks also declined, though by far less, reflecting the more limited exposure to Russia.

The latest moves mark a turnaround from the early reaction to the assault on Ukraine. An initial drop in stocks after the war started was followed by a rally, helped by a “buy the dip” mentality and speculation that central banks would back off on interest-rate hikes. Strategists at JPMorgan Chase & Co. and Citigroup Inc. pushed the idea of short-lived pain and that history pointed to the emergence of buying opportunities.

The contrast between hopeful markets and the messages from politicians was stark, but any optimism is crumbling as the Russian attacks intensify. 

And far from being temporary, it's more likely that sanctions will be sustained and possibly strengthened, exacerbating the pressure on countries already struggling to contain seemingly unstoppable inflation.

“It is interesting that the market did not believe that the war would start a month ago, then we did not believe that it would escalate past Donetsk and Luhansk, so, it is a bit of a denial trade,” says Marija Veitmane, senior strategist at State Street Global Markets.

Europe's Stoxx 600 Index fell 3.6% on Friday, capping its worst week since the early days of the pandemic in 2020. The S&P 500 slipped 0.8%, a fourth decline in five days.

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The shock of the war -- Russia had repeatedly denied it would invade despite its troop build-up -- has catapulted commodity prices from gas and oil to wheat and aluminum to fresh records.

That's increasing a squeeze on companies and households, with damaging implications for investment, spending and growth. So great is the threat, particularly for Europe, that the specter of stagflation has re-emerged.

“Beyond energy there is the risk of shocks to other commodities given global linkages for all types of input chemicals,” said Matt Peron, director of research at Janus Henderson Investors. “So far, however, these issues remain contained and are likely to be manageable if the conflict and resultant production issues are short lived. If it stretches on, the ripple effects will be significant.” 

In addition, the conflict may signal the start of a fundamental decoupling between Russia, one of the world's major energy and commodity producers, and Europe and the U.S.

Diplomats and European Union officials in Brussels say that even if military operations in Ukraine conclude and Vladimir Putin's armies prevail, this will only reinforce the sanctions targeting Russia's central bank as well as its lenders and industrial champions. Sanctions will be eased only if Putin reaches a consensual compromise with the government of Ukraine, a scenario that appeared, as of Friday, unlikely.

Read More: Biden Says Putin ‘Has No Idea What's Coming'

For Dimitris Valatsas, chief economist at Greenmantle, the best historical analogy is the oil rally, inflation spike and demand destruction that followed the collapse of Iranian production in the late 1970s.

“With wholesale gas prices nearly 10 times higher than they were a year ago and crude oil prices nearly double, the European household will take a heavy hit to disposable income,” he said. “This will depress consumption more broadly and thus hurt companies with European consumer exposure.”

By some measures, the gloom is more pronounced than it appears from the moves seen immediately after the outbreak of the war. 

Paul O'Connor, head of multi-asset at Janus Henderson, noted that euro-area stocks are now trading at a 25% discount to consensus analyst targets, “a level of distrust only previously seen in the U.S. sub-prime crisis, the euro debt crisis and the early days of the pandemic.”

But not all sectors have suffered. European renewable energy stocks surged as much as 24% and the likes of Vestas Wind Systems A/S rallied amid expectations that the invasion will cement Europe's political will to accelerate the transition away from fossil fuels.

Similarly, defense stocks soared as Germany reacted to Russia's aggression with a pledge to reverse decades of restraint in military spending. Miners and energy are now the only sectors which have posted gains this year in the Stoxx 600, a wager that the commodities rally will continue.

So where can investors put their money?

“High quality companies that provide sustainable dividends,” says Peron at Janus Henderson. “While inflation is generally challenging for markets in that it compresses margins, lowers multiples, and elevates the risk of more aggressive central bank policy, on a relative basis, sectors with pricing power typically outperform.”

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