The Russian invasion of Ukraine in late February, and the ongoing political response, has clouded our outlook on equity sectors. Due to the unprecedented and volatile series of events, the economic and market landscape has become highly uncertain.
Until there is more clarity on how the sharp rise in commodity prices, tightening of financial conditions, and likely Federal Reserve interest rate hikes might impact the economy and underlying fundamentals that drive relative sector performance, we think it’s prudent to maintain sector allocations that are in line with the overall market. Therefore, we’re returning the Financials and Health Care ratings to neutral from outperform, as well as moving the Industrials and Materials ratings to neutral from underperform.
Commodity prices have surged
Prior the Russian invasion of Ukraine, there were already imbalances in the commodities market that drove prices to record highs, in some cases. The massive stimulus—both monetary and fiscal—spurred demand for commodities to the extent that supply could not keep up. This became worse as many commodity producers—particularly those in the oil and gas industry—held back production amid higher wages, surging transportation costs, and worries about a sudden reversal in prices as has happened during previous commodity price spikes.
When Russia—the world’s largest exporter of oil—attacked Ukraine, the international community responded with harsh sanctions. While the first salvo of sanctions were designed to cut Russia off from the global financial system and avoid affecting their oil exports, many refineries and energy traders refused to buy Russian oil due to the risk of inadvertently violating those sanctions, as well as in solidarity with Ukraine. Outright embargos of Russian oil imports by the U.S. and other countries cemented the boycott by the private market.
Oil is not the only commodity being affected. Russia is also a major exporter of wheat, as well as natural gas, metals, and fertilizer. Along with these, prices of most commodities have surged—with few indications as to when traders’ fears and demand for those commodities will subside or the geopolitical firestorm will ease. This is likely to continue to result in outsized and rapid fluctuations in commodity prices, making it even more difficult to hold views on sectors influenced by them—such as Energy and Materials.
Prices are up sharply for most commodities
Source: Bloomberg as of 3/9/2022 The S&P GSCI Energy, Agriculture and Industrial Metals Indexes provide investors with a reliable and publicly available benchmark for investment performance in the energy commodity market.
Financial conditions are in flux
As is the case with most major events—whether they be market, economic, or geopolitical—investors, borrowers, and creditors are compensating for higher risks by reallocating to safe-haven securities, raising cash and/or charging more to take risk—all of which can reduce liquidity and tighten financial conditions. This is being compounded by the likelihood that the Federal Reserve is about to begin raising short-term interest rates to ease demand and tamp down inflation. Its goal to navigate a soft landing in the economy has only become more challenging—raising the risk of a policy mistake that either fails to tame inflation or puts the economy into a recession. Until we have more clarity on the Fed’s chances for success, forecasting interest rates and the impact that could have on sectors—such as Financials and the REITs that make up the bulk of the Real Estate sector—is much more difficult.
Financial conditions have tightened
Source: Bloomberg as of 3/9/2022 The Bloomberg U.S. Financial Conditions Index tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions relative to pre-crisis norms.
The impact on the economy is uncertain
Prior to the invasion, we were already seeing some slowing in the rate of economic growth—though the risk of recession remained low. However, the energy crisis is likely to continue to weigh on business conditions amid rising input costs and tighter financial conditions. And although the job market remains very strong, consumer confidence has plummeted, which threatens consumer spending—particularly as wage gains are being more than offset by surging inflation. While it’s unlikely that we’ll experience 1970s-style stagflation, the risk of a recession has increased. This argues for leaning into defensive sectors, such as Health Care, Utilities, and Consumer Staples. However, with a lot of investor anxiety likely already priced into the markets, any positive developments in the Russian war—even if fleeting—could precipitate a very strong rally in the markets, in which case the defensive sectors could sharply underperform.
Economic sentiment has deteriorated
Source: Bloomberg, Federal Reserve as of 3/9/2022. The Federal Reserve Daily News Sentiment Index is a high frequency measure of economic sentiment based on lexical analysis of economics-related news articles.
Eventually, these issues will resolve themselves. But in the meantime, the markets are likely to be very volatile as investors try to make sense of the unprecedented confluence of these global geopolitical and macroeconomic events. We’re likely to see surges of relief that quickly unwind the frenetic responses to the crisis, potentially followed by renewed uncertainty. It’s never easy to forecast the relative performance of sectors, but in the current environment it is particularly challenging. Accordingly, we recommend investor align their sector allocations in line with those of the overall market.
What do the ratings mean?
The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:
- Outperform: likely to perform better than the broader stock market*
- Underperform: likely to perform worse than the broader stock market*
- Neutral: no current view on likely relative performance
* As represented by the S&P 500 index
Important Disclosures:
Schwab Sector Views do not represent a personalized recommendation of a particular investment strategy to you. You should not buy or sell an investment without first considering whether it is appropriate for you and your portfolio. Additionally, you should review and consider any recent market news.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Diversification and asset allocation do not ensure a profit and do not protect against losses in declining markets.
Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For more information on indexes please see www.schwab.com/indexdefinitions.
Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.
Investing involves risk including loss of principal.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
Commodity‐related products, including futures, carry a high level of risk and are not suitable for all investors. Commodity‐related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held.
Real Estate Investment Trusts (REITs): Risks of REITs are similar to those associated with direct ownership of real estate, such as changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer. Investing in REITs may pose additional risks such as real estate industry risk, interest rate risk, risks related to the uncertainty of and compliance with certain tax regime rules, and liquidity risk.
The Schwab Center for Financial Research (SCFR) is a division of Charles Schwab & Co., Inc.
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