Escalated tensions

Market Overview from Quilter Cheviot

By Alan McIntosh, Chief Investment Strategist

Russia’s invasion of Ukraine last week was a shocking event and the largest military incursion in Europe since the Second World War. As we watch events unfold on our TV screens it is difficult to predict where this ends. Western countries have imposed strong sanctions on the Russian banking sector to starve it of funds. This will unquestionably hit the Russian economy. At the weekend Germany announced a dramatic change of policy, promising to massively increase military spending, something it had pledged never to do. The market reaction has been predictably volatile. A selloff in equities on Thursday was followed by a sharp rally on Friday, leaving markets relatively flat on the week. Energy prices have risen again, reflecting the importance of Russian exports of gas into Europe, particularly to Germany. It is too early to tell whether sanctions will limit or halt oil and gas trade with Russia.

While a rise in oil and gas prices will contribute to higher general levels of inflation, there is another impact, which will be to reduce disposable incomes of households. Central banks have been talking recently about the need to raise interest rates to get inflation back to target levels. However, oil prices are now 25% higher than they were at the end of 2021, and this will have a significant effect on energy bills for individuals and for businesses. This will ultimately lead to slower economic growth. The challenge for central banks now will be to balance the inflationary pressure of higher energy costs against the negative impact these will have on growth. While it is unlikely that the UK or the US will abandon their stated intention to raise borrowing costs, there is a strong argument to suggest that rate rises this year may be less aggressive than markets have been recently forecasting.

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