Ear to the Ground: Conflict in Ukraine
Within this article we focus our attention on the conflict in the Ukraine and the impact it has had to date on financial markets and the economy. Firstly however, we acknowledge that the invasion of the Ukraine by Russia has captured the thoughts and feelings of people across the world, with many condemning their actions. I am sure you have all seen on the news the very unfortunate events which have occurred and indeed are still ongoing. Our thoughts go out to those who have been affected, both directly and indirectly.
Since the incursion began on the 24th February markets have seen a sharp rise in volatility, both equities and bonds, with the degree of the move varying across them. After an initial sharp fall in equity markets it was perhaps a little surprising that we then saw a degree of stability. As Friday’s and today’s trading session is reminds us however, this can prove short lived. On Friday the FTSE 100 closed down almost 3.5% whilst today, at the time of writing the index is down a further 1.5%.
The impact of geopolitical events, in particular war, are highly visible in terms of the unfortunate destruction seen, the ramifications for financial markets and economies can take much longer to understand and come to fruition. There are a number of areas where the impact has been seen heavily. The first is Russian assets themselves. Sanctions have been imposed by many countries around the world regarding trading with Russia and companies within it. The most prominent perhaps is the inability of the Russian major banks to use the SWIFT system. This is a system which allows banks and financial institutions to communicate with each other, enabling transactions such as money transfers. This has been followed over the weekend by the news that that Visa and Mastercard are to suspend their payment facilities in the country.
We have also seen a large number of companies now either refusing to trade in or with Russia and Russian companies. The most prominent have been western oil and gas companies such as Shell, BP and Exxon who have been willing to walk away from joint ventures at a cost of billions of pounds in order to sever ties. We have also retail names such as Apple, Microsoft, Nike and Netflix, to name but a few, refuse to sell their products and services within the country and have withdrawn.
Despite a desperate attempt to prevent a sell-off in Russian equities by closing the stock exchange, this has failed to prevent a collapse in prices. Many of the large Russian firms, such as banks, trade in overseas markets through Global Depositary Receipts (GDR), a certificate which represents shares in a foreign stock on two or more markets. In respect of Russian equities these have been marked down pretty much to zero value in overseas markets by investors. Fund management groups, such as Fidelity and BlackRock, as a consequence have written down to zero any holdings which they had in Russian investments. The latter, along with others, have also suspended Russian purchases across all of their active and passive investment range.
MSCI, who create many of the indices which passive and indeed active investors follow in terms of guiding asset allocation, are also taking action. They are to remove Russia from all emerging market indices and instead classify them as a standalone market. This could result in a further large amount of capital being withdrawn from Russia, particularly by those passive investment vehicles following emerging market indices. It is not just equities where we have seen heavy prices falls. Russia bonds have also been priced down significantly, with government bonds currently not paying any coupon payments to overseas investors who have placed sanctions against Russia. Russia has become uninvestable.
One of the most affected areas of the market has been commodity prices. It is well known that Russia is a large exporter of energy in the form of oil and gas, in particular to Europe. Both were already seeing their price rise due to supply constraints, but the conflict has exacerbated this. There are fears of supply disruption plus we are now seeing some countries refusing to buy supplies from Russia. As we write the WTI crude oil price is approaching $125 a barrel and you have no doubt seen the headlines of record prices for fuel at the petrol pumps here in the UK. This is not only inflationary but can place downward pressure on economic growth, especially in countries which are large importers of their energy requirements.
This is not the only commodity however which has seen a sharp rise in price. Russia and Ukraine are two of the largest global exporters of wheat, for example. As a result of sanctions and fears over supply the wheat price, according to data from Bloomberg, now stands at a 14 year high. Russia is also a large producer of potash fertiliser, the higher cost of which is feeding in to food prices. Russia are meaningful producers of other commodities such as platinum and nickel. As a consequence of these higher commodity prices it is now possible that inflation will peak higher than initial expectations. Not only that, but higher inflation may be with us for longer and that when inflation does recede it may settle at a higher level than previously forecast.
This leaves central banks in something of a predicament, especially the US Federal Reserve and the Bank of England. There were many interest rate hikes priced in for this year on the back of already climbing inflation. Concerns that the conflict, supply disruptions and higher commodity prices might slow down economic growth have tempered these expectations, although there are still a number priced in. Here, therefore, is the heightened risk of a policy mistake. Do central banks hike in order to try and bring inflation down with the risk being that they choke economic growth, or do they pause hiking with the risk being that inflation gets out of control? They are clearly in a more difficult scenario under which to make their decision, but their creditability remains at risk all the same. Stagflation, a period of falling growth yet rising inflation, is never welcomed by bond or equity investors.
History shows that geopolitical shocks can have a relatively short lived impact on financial markets, with any drawdowns being reversed over time. At this point in time we believe that we, along with most investment market analysts and strategists who we have heard from, have to be humble in admitting that we are not experts in warfare, or have any greater knowledge as to which path this conflict, or indeed Russia will take. As always we will continue to monitor portfolios and will recommend changes and adjustments when necessary.
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