28 February 2022, A message from Dan Farmer, Chief Investment Officer
After weeks of escalating tension and US statements that Russia will attack, Ukraine is now under invasion. As the world watches on while the tragedy of war unfolds, what will the impact on financial markets be?
Russia’s military action in Ukraine is first and foremost a human tragedy. Many lives will be lost, and people’s homes, livelihoods and families destroyed. While discussing the investment and economic implications may seem insensitive, we want to provide you with some helpful background and context, as well as our investment view.
What is at stake?
Russia asserts that NATO took advantage of the collapse of the Soviet Union by making inroads into countries who gained independence when the union disintegrated. Going further, Russia asserts that Ukraine risks its integrity as a nation as Ukraine is an artificially created entity rather than a sovereign state.
The US and EU have challenged Russia, arguing that Ukraine has the right to determine its own destiny whilst being under no obligation to defend this position as Ukraine isn’t a member of NATO.
Russia’s invasion elevates the risk to the post-world and cold war rules-based system, so there’s a lot at stake, particularly as rising powers like China also wish to re-write the current global trading system.
What’s the impact?
- Energy prices
Russia is the world’s third-biggest oil producer and second-biggest producer of natural gas, and the country is the source of up to 40% of Europe’s gas.1 Germany has now suspended but not rescinded the Nord Stream 2 gas project — the undersea pipeline directly linking Russian gas to western Europe via Germany (and bypassing existing pipelines running through Ukraine and Poland). Meanwhile, the United States has imposed sanctions on Gazprom, the Russian state-owned giant running the pipeline.
Despite Nord Stream 2’s suspension, the Russia-Europe energy relationship has not ceased. Russia needs gas customers, and Europe particularly Germany needs gas. This interdependence suggests that the relationship will continue, at least for now, no matter how high tensions may be. However, Europe needs to reduce its carbon-based energy dependence.
All of this is a business-as-usual assumption when things are anything but normal. Recent energy prices have spiked on fear and uncertainty with Brent crude futures jumping past US$100 a barrel for the first time since September 2014.2 All up we consider the risk of a sustained surge in energy prices has risen, but this isn’t our base case.
- Finance and technology
Given the sensitivity of energy security, US, EU, and UK sanctions have been primarily financial and technology access related. However, financial sanctions directed at banks, corporates and oligarchs have stepped back from freezing Russia out of the global SWIFT system (the vast messaging network used by banks and other financial institutions to securely send and receive information, such as money transfers) that would be particularly crippling.
At this stage the European countries who rely heavily on Russia’s energy resources have argued against expulsion from the SWIFT system. This means the current sanctions are more of a prolonged freeze rather than a sudden stop. Russia had already built up considerable financial reserves, so sanctions are unlikely to impede the invasion but more of a steady degradation.
Overall, we expect to see an acceleration of strategic trading alliances, and a further step away from the open global trading system, including the rise of China and tariff reductions, that has helped to moderate inflationary pressures over the last 20 years or so. This means the risk of a higher pace of inflation is likely to steadily build.
Given already high inflation, on the back of stressed supply chains, the invasion of Ukraine will only add to these pressures. While central banks haven’t had to raise rates on war-induced energy spikes in the past, with inflation already at eye-watering levels they won’t be able to turn a blind eye like they could have done in the last 20 years or so.
The prospect of even higher inflation on the back of potentially steeper energy and commodity prices, on one hand, coupled with some risk to economic growth as higher prices crimp demand on the other hand, is a ‘worst case’ scenario.
What will happen next?
Trying to work out where financial markets go from here is challenging. We expect that market volatility could remain elevated for some months as military action plays out, likely undeterred by the current sanctions.
There isn’t always a direct link between geopolitical shocks and financial market responses, and this type of conflict isn’t in the history playbook, although global energy spikes have occurred before. What we do know is that the current crisis is occurring against a backdrop of an overheating global economy, supply shortages and high and rising inflation which is likely to reduce central banks’ ability to offset any growth hit should the conflict persist and widen.
Large conflicts are generally inflationary, and most have coincided with or contributed to rising bond yields. However, while we expect this to be a relatively constrained event, the risk around energy and commodity prices remains the key risk to global financial markets.
So far, the invasion has produced more of a flight to quality assets on higher volatility, rather than a sharp spike in inflation concerns. However, over time, the inflation risk could begin to re-establish and overwhelm the near-term flight to quality.
As it is, our portfolios have limited share market investments in Russia and even before the events underway, we had been preparing for changes in the investment environment. For instance, we had been directing more towards “alternative assets’, which we think are likely to perform differently to traditional assets, in times of market stress and a steady lift in inflation.
Sizeable levels of exposure to unlisted assets, such as infrastructure, private equity, and real estate, also help to provide some protection from share market volatility.
It’s by sticking to time-tested principles like diversification, active-management and risk control that give us confidence that we can help our clients’ portfolios through what may lie ahead.
1What Russia’s Invasion of Ukraine Means for the Global Economy, by Pierre Briancon, 22 February 2022, https://www.barrons.com/articles/russia-invasion-ukraine-global-economy-5164554692
2Russia-Ukraine crisis: What’s next for global energy prices?, by John Power, 24 February 2022, https://www.aljazeera.com/economy/2022/2/24/russia-ukraine-crisis-whats-next-for-global-energy-prices
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