Stocks rebound as oil prices retreat

Originally published as a CIO Alert by Mark Haefele, Chief Investment Officer for UBS Global Wealth Management

What happened?

The S&P 500 closed 2.6% higher, after previously declining for four consecutive sessions, as oil prices retreated from multiyear highs on Monday—Brent crude fell 11.9% to USD 112.71/bbl—alleviating fears about the negative impact of high commodity prices on the global economy. Earlier in the day, the Stoxx Europe 600 finished 4.2% higher. Safe-haven assets gave back gains, with gold dropping by 2.4% to USD 1,995.2/oz and the DXY dollar index depreciating by 0.9%.

Bond yields rose amid the risk-on sentiment and ahead of US CPI data and the European Central Bank’s monthly policy meeting on Thursday. Ten-year US Treasury yields rose by 9 basis points to 1.94%, having traded as low as 1.67% on Monday. Ten-year German Bund yields rose by 10bps to 0.22%. Federal funds futures markets moved to price in additional tightening by the Federal Reserve, expecting more than six 25bps hikes this year and more than eight by mid-2023.

Investor sentiment appeared to be buoyed by comments from one of President Volodymyr Zelenskyy’s aides that Ukraine was open to discussing neutrality, subject to security guarantees, which followed news reports on Tuesday that Ukraine was no longer insisting on NATO membership. On Monday, Kremlin spokesman Dmitry Peskov told Reuters that if Ukraine put neutrality in its constitution, recognized Crimea as Russian territory, and recognized Donetsk and Luhansk as independent states, Russia would not pursue any further territorial claims, nor a handover of Kyiv.

The move may also reflect technically oversold market conditions following four sessions of declines in stocks, and a view from some traders that the US ban on Russian oil and gas and the more incremental approach by Europe was already factored into market prices at current levels.

How do we interpret this?

Today’s news flow is supportive of our central scenario in which energy sanctions only contribute to the gradual removal of Russia from global energy supply chains, rather than forcing an immediate halt to energy flows. Any cease-fire would reduce the chance of new additional sanctions on Russian energy, and although the US has already banned Russian fossil fuel imports, only about 8% of Russia’s oil exports go to the US, versus around 60% to Europe. Europe’s approach continues to be for a more gradual reduction in the region’s dependence on Russian energy.

In this scenario, we would expect Brent crude oil to trade around USD 125/bbl until June, but fall back to USD 115/bbl in September and USD 105/bbl in December. A few months of elevated commodity prices would likely hurt growth and corporate earnings, but in this scenario we would still expect earnings growth to remain positive overall for 2022. Our S&P 500 target in this scenario is 4,800.

In a downside scenario, we experience a more abrupt disruption to Russian energy flows into Europe, either through European nations following the US lead, disruption due to the war, or a Russian decision to cut off exports. In this scenario, oil prices could rise above USD 150/bbl, and gas may need to be rationed in Europe. Should this materialize, we would expect a significant negative impact on economic growth and corporate earnings in Europe, stretching into 2023. Our S&P 500 target in this scenario is 3,700.

Investment recommendations

While volatility is likely to persist, the rise in equities on Wednesday offers a reminder that markets can turn swiftly. It also underlines our view that simply selling risk assets is not the best response to the war in Ukraine. Instead, we favor strategies that provide downside protection while focusing on long-term returns.

In this environment of heightened uncertainty, we recommend investors take actions that will help their portfolios navigate market volatility:

1. Build up portfolio hedges. For investors whose equity holdings are above long-term strategic allocations, it makes sense to bring stock holdings back to neutral. We also see other ways to make portfolios more defensive in the current environment. Given the war in Ukraine, we think broad commodities remain an effective portfolio hedge. Energy equities, still a preferred sector, are also likely to benefit in the event of further increases in commodity prices. We also see the global healthcare sector, the use of dynamic asset allocation strategies, and structured solutions as potential means of reducing portfolio volatility. In the short term, we also believe the US dollar can act as an effective portfolio hedge. 
2. Position for the energy transition. The recent ban on Russian oil imports by the US—along with the EU goal of reducing reliance on Russian natural gas imports—points to an increased focus on energy security and independence. We see this trend gathering pace due to the war in Ukraine. The desire for energy independence chimes with the longer-term focus on reducing carbon emissions. We believe this is likely to favor investment in greentech, and clean air and carbon reduction solutions. 
3. Diversify with alternatives. The war in Ukraine, combined with concerns about inflation, is driving higher portfolio volatility. This makes diversification across different regions, sectors, and asset classes more important. Hedge funds can also help diversify portfolios beyond stocks and bonds and may help reduce overall portfolio volatility. Certain hedge fund strategies are specifically designed to outperform during periods of volatile or falling markets. Meanwhile, exposure to private markets can help keep investors well positioned for long-term returns.

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