The return of geopolitical tension in Europe has not done markets across the world any favours. Russian equities have experienced a selloff, with the MOEX Russia Index down by a fifth since the invasion started. The Russian rouble also hit a new low against the green back, while Russian 10-year government bond yields surged to its highest in years.
These have led Tatiana Orlova and Innes McFee, lead economist and global chief economist at Oxford Economics respectively, to reduce their baseline for Russian GDP by 1.2% by 2023. MSCI, which builds indices used by the market to trade, said it would drop Russian stocks from its widely-tracked emerging markets indices, warning that the country’s equity market had become “uninvestible” as the list of sanctions grows.
Markets outside Russia fell in reaction initially. And in the week that followed, there were big swings in both directions, throwing forecasts out of whack.
Unsurprisingly, given the scale of Ukraine’s agricultural exports and Russia’s oil and gas muscles, the energy and commodities space experienced a big surge, with crude oil rushing past US$110 ($149) per barrel.
Even small, forgotten oil and coal plays here on the Singapore Exchange became the counters with the biggest percentage gains, amid heavy punting volume.
However, cooler heads are warning against the euphoria. “The energy market is exceptionally uncertain and we refrain from revising our forecast over the near term,” says UOB economist Heng Koon How on March 3.
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Opec+, the club of major oil producers, chose to maintain existing production levels despite the higher prices and fears of shortages. “Global consumers are now increasingly worried of the developing supply crunch. The developing ‘Russian oil shock’ as it is now called is increasingly compared to the previous Middle East oil shocks of the ‘70s,” notes Heng.
Nevertheless, investors looking for a bet will find plenty of choices. Energy and gold aside, Stefan Kreuzkamp, chief investment officer at DWS, says that safe havens such as US equities, healthcare and consumer staples are likely to outperform.
However, cyclical sectors and Europe ex-UK equities are likely to be in for a rough ride. Eurozone financials will struggle with delayed rate hikes by the European Central Bank and disentangling its relations with the Russian financial system.
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“We believe that energy will carry a risk premium for a prolonged time. This in turn makes the central bank’s reaction more difficult to predict. While they will be tempted to stimulate the economy if needed, or at least not tighten financial conditions too fast, they might be confronted with potentially higher inflation rates for a longer period than anticipated,” Kreuzkamp adds.
With oil prices crossing US$110, economists are warning of further inflationary woes. “Our modelling of the energy shock suggests a higher near-term peak in US CPI inflation and a slower decline through 2022. Consumer prices (CPI) now look likely to rise over 6% on an average annual basis in 2022,” says Kathy Bostjancic, chief US economist at Oxford Economics.
US Federal Reserve chairman Jerome Powell on March 2 said that despite the invasion of Ukraine, he would propose a quarter-percentage point rate increase in a fortnight’s time, amid decades-high inflation, strong economic demand and a tight labour market.
In short, the US Fed is sticking to its guidance on the pace of rate hikes. “For now, I would say that we will proceed carefully along the lines of that plan,” says Powell.
Already high US inflation is likely to worsen as US 10-year bond yields reached 1.93% while the US dollar index rose 1.2%. European yields, which are more dependent on Russia’s energy supply, would come under greater pressure than the US. DWS sees treasury yields flattening on the longer end of the yield curve (10y to 30y) and are cautious on European corporate bonds.
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Commodity concerns
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In the long run, there will be much soul-searching in Europe over its energy future in the wake of this episode. Meghan O’Sullivan of the Harvard Kennedy School warns that Europe will need to pay more attention to its immediate energy security issues by investing more in natural gas infrastructure to diversify its suppliers.
Paradoxically, however, they will also need to speed up their transition to green energy to avoid being held to ransom by Russia and other gas suppliers in the medium and long term. “Russia, too, would lose much. At current prices, it would give up US$7.5 billion of [gas] revenues a month, possibly more. In the tussle between Russia and the EU over gas imports, business as usual remains the most pragmatic, and likely, outcome,” notes a press release by Wood McKenzie.
Though the US has ruled out direct sanctions on Russian oil exports, natural resource consultancy Wood McKenzie still expects further tightening in the supply and demand balance going forward, with OPEC seen to use spare capacity to offset losses.
As there are few metal extraction and processing production facilities of scale in Ukraine, disruption to metal production is likely to have a relatively small global impact. A disruption to production and export of certain commodities such as platinum and aluminium group metals and iron ore, however, could worsen the market’s current supply pressure.
Limitations on the ability of Russian producers to import and export as well as the ability of counterparties willing and able to transact with offshore entities could be more serious. Metal and mining firms that have shareholders linked to the Kremlin could be at risk. Russia’s economy is better able to withstand sanctions today as compared to its invasion of Crimea in 2014.
Wood Mckenzie notes that Moscow has built a reserve cushion to soften the blow in the short term, though being frozen out of international bond markets will require new sovereign debt to be financed domestically. Russian reserves are seen to cover the US$50 billion Moscow owes in principal repayments on government debt through 2025.
Fog of War
Ultimately, however, markets remain uncertain and, therefore, volatile in response to the fast-changing situation. Credit Suisse’s Investment Committee is staying neutral on equities despite the immediate market weakness, preferring instead to “wait and see” as the situation on the ground evolves.
Credit Suisse’s current focus is now on risk management to ensure that its portfolio can weather the present geopolitical storm, with fixed income held underweight and more emphasis given to cash and alternative investments.
“With this dawn of a new world order, investors should carefully choose their asset allocations. Systematic and strong investment processes and due diligence procedures before investing will become even more crucial. Active investing will become more important given the potential for shifting economic, political and social developments in individual regions,” notes Strobaek.
Standard Chartered believes that adding portfolio hedges would be helpful in riding out near-term volatility going forward. It prefers gold due to its reliability as a hedge against market volatility, safe-haven currencies like the Japanese Yen. Holding cash would be helpful to ensure that investors can act on any investment opportunities emerging from this crisis.
Nestorovic of ESSEC recommends that firms exposed to Russia or Ukraine look for alternatives immediately. “Even if the war ends quickly, businesses will need time to resume operations. It will take months to recover from the upheaval of that magnitude,” he tells The Edge Singapore. Given that reputational risks from dealing with Russia will likely be as big as the operational risks, he urges businesses to “act quickly” to disengage.
Oksana Antonenko, director at Control Risks, says that businesses are facing the most significant geopolitical risks since the Cold War — and perhaps ever — as globalisation exposes them to the fallout of the war. “Geopolitical risks will remain high for businesses around the world, and operation and security risks will be much higher than we were accustomed to in first two decades of the 21st century,” she says. Sanctions are likely to become more complex and strictly enforced, while supply chain re-routing is seen to accelerate.
But given the present uncertainty, the best thing that businesses can do is to wait and stay vigilant. Antonenko says that firms should monitor global developments and ensure that they have robust risk mitigation and compliance systems in place.
With both Covid-19 and the war in Ukraine heralding a world where “black swan” events grow ever more common, firms are advised to plan ahead and use scenario analysis and stress-testing to build resilience.
Demonstrators protest against Russia's invasion of Ukraine in New York City / Bloomberg
