Only a couple of months ago, investors were focussed on hoping for an end to the pandemic; now all headlines are dominated by the Russian and Ukrainian war. After months of amassing troops near the Ukrainian border while negotiating with the West, Russian President Vladimir Putin finally declared “a military operation” on 24 Feb. In the following weeks, Europe has seen its worst war since World War II. More than 2 million Ukrainian refugees have fled the country within two weeks.
Tensions rose last year between Russia and Ukraine due to the latter’s desire to join the North Atlantic Treaty Organization, which Russia views as a security threat. Since the former Soviet Union broke apart after the Cold War, NATO, the US-led military alliance, has quickly expanded to the East. In response, Moscow demanded that Ukraine not join NATO, and insisted NATO forces return to where they were stationed in 1997.
Since the invasion, Western countries have imposed a series of economic sanctions hoping to limit the Kremlin’s ability to finance its war. The US Treasury Department immobilised Russian central bank assets that are held in the US, and imposed sanctions on the Russian Direct Investment Fund, a major sovereign wealth fund.
Financial institutions outside the US, which hold dollars for the Russian central bank, cannot move them. As a result, Russia cannot access the $630 billion in forex reserves it has built over the years, to support its currency. The ruble depreciated by 45% within two weeks. After a sharp selloff, the Russian stock market halted trading from 25 Feb.
A number of countries planned to remove selected Russian banks from SWIFT, a global financial artery which allow rapid transfer of funds across borders. This action will make international transactions increasingly difficult.
On 8 March, US President Joe Biden announced a ban on all Russian fossil fuel imports, including oil and gas. The UK joined with a ban on Russian oil imports, though it did not ban natural gas and coal. With a quarter of the European Union’s oil imports coming from Russia, along with 40% of its gas, the EU will not join in banning these energy imports. Nonetheless, the EU announced its plan to cut dependence on Russian gas by almost 80% this year. The Nord Stream 2 natural gas pipeline, which was designed to deliver gas from Russia to Germany, has been suspended.
Russia is the second largest oil exporter in the world and its war with Ukraine has shot crude oil prices past $120, the second highest in history. The American Automobile Association said the average US regular-grade gasoline price hit $4.009 per gallon last week, up 45% from a year ago, adding more upward pressure to already hot inflation. As a net oil exporter, the US. has the capacity to increase output, but it will take drillers some time to expand production enoughto make up for the shortfall.
More than 100 companies have pulled out of Russia in an effort to boycott the country due to its invasion of Ukraine. Multinational companies from the financial, entertainment, retail, shipping and automobile industries have stopped their business in Russia. Among those companies are Apple, Netflix, Disney, Mastercard, Visa, American Express and Ikea. Even though the Russian economy will be in deep recession this year, economic pressure likely won’t be enough to force Putin to retreat. Given Putin’s risk-seeking character, Russia’s oppressive leader could act even more aggressively, especially given his better-equipped military forces and penchant for ‘winning’ at all costs.
Fortunately for investors, the Russian economy only makes up 1.7% of global GDP and therefore global growth may be dented only modestly. However, the immediate impact is more severe in its smaller emerging market trade partners. To name a few, Turkey, Egypt, Vietnam and the Philippines are vulnerable to higher import costs and lower exports. On the other hand, net oil exporters such as Saudi Arabia or Brazil will benefit from higher energy prices.
The European economy will likely suffer a significant slowdown because of higher energy prices. However, we are now exiting the winter season when demand for gas heating is steadily becoming less critical. In 2021, Russia was the fifth largest partner for EU exports of goods at 4.1% and the third largest partner for EU imports of goods at 7.5%.
The direct impact on US companies’ earnings should be limited, but the indirect impact resulting from higher inflation will be more pronounced. For example, Russia and Ukraine combined export 29% of the global wheat supply. With sanctions on Russia and the closing of Ukraine’s ports and factories, wheat prices have risen by 67% so far this year. The surge in wheat price affects many food items from cereal to cooking oils, as well as meat prices since grains are used to feed livestock.
The pandemic-triggered supply chain bottleneck has now been worsened by the geopolitical uncertainty. Ukraine produces around 70% of global neon gas, which is critical in the semiconductor industry. With Russia closing its air space to 36 nations, air freight will get more expensive as planes must take longer alternative routes. Russia produced 17% of world’s high-grade nickel, which is widely used in electric vehicle batteries. The fear of supply shortage pushed nickel prices to more than double in a single day, triggered by a shortage squeeze.
On the plus side, geopolitical tension adds resistance to the US growth rebound and should thereby temper the central bank’s hawkishness. During the Fed chairman Jerome Powell’s testimony in front of Congress on 1 March, he stated his preference for a 25 basis point rate hike for the 16 March FOMC meeting, unless inflation gets much higher. Earlier forecasts included a Fed rate hike of 50 basis points.
The VIX index, a measure of equity market volatility, has been higher this year than last year’s average. We expect volatility to remain high in the short term. Even if the war ends within a short period, the effect on deglobalisation will likely linger. After a sharp rebound from the pandemic-driven recession last year, major economies’ GDP were forecast to normalise this year even prior to the war breaking out.
For investors with a longer term time horizon, market selloffs have historically presented opportunities to buy solid companies at low prices. We continue to focus mainly on the US market which is more removed from direct impacts, while staying cautious about Europe and most emerging markets. Even though the likelihood of NATO joining the war is minimal, significant financial ties between Europe and Russia will have more severe economic impact on the EU directly.
Despite ongoing high inflation, 76% of the S&P 500 companies exceeded earnings estimates in the previous quarter. Within the S&P index, energy companies have led the gains this year, benefiting from higher oil prices. Defensive sectors such as utilities and consumer staples have also shown resilience. In the past, commodities, real estate investment trusts and dividend stocks have proven to be good inflation hedges.
Nan Wang, CFA is a portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact the Cayman office of LOM at (345) 233-0100 for further information.
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