Aerial view of Kiev in winter snow.

Investment Management –

Market Flash - 4th March 2022

Welcome to Market Flash – a communication designed to give you time-sensitive information regarding the material events that impact the markets.

What are the short, medium and long-term impacts of the Russia/Ukraine War?

 

Short-term:

War has engulfed Europe once again. The tragic reality is that the freedom and safety of Ukrainian citizens is at risk, which has led to a humanitarian disaster in Eastern Europe.  The UN has estimated that over 900,000 people have fled to host countries such as Poland, Hungary and Romania.

The international response has been rapid. European & US airspace is closed to Russian flights, certain Russian banks have been removed from the SWIFT messaging system, the Central Bank has been sanctioned, and Russian sovereign bonds have been downgraded to junk status. Furthermore, governments around the world are announcing measures to isolate President Putin’s administration. We have also witnessed symbolic gestures from large corporations, sporting associations, and media organisations in solidarity with Ukraine.

How have Russian markets reacted? The Ruble has declined significantly, Russian equities have sold off (now largely untradable) and Russian securities are being removed from indices. 

More broadly, globally stocks have been very volatile, safe-haven assets have rallied, and oil and gas have shot up materially. There is also the ‘small’ matter of monetary policy which I cover later in this Q&A.

 

Medium-term:

Sadly, net zero and de-carbonisation will take a backseat to increasing military expenditure. This week, German Chancellor Olaf Scholz said, “Everything has changed…” This means that European military expenditure (in addition to the UK) will ramp up materially. The headline figure out of Germany was EUR100bn, followed by a promise from the French President to also increase defence spending. This means a massive military build-up on the Eastern flank is now inevitable. 

Could we even see countries like Romania and Moldova merge? Tough to assign a probability to that and not my area of expertise but anything is possible in the fog of war.

And of course, on the energy front, European governments will now be forced to reduce their exposure to Russian natural gas and oil (especially Germany), so don’t be surprised if nuclear reactors start making a comeback at a power plant near you!

 

Longer-term:

From a geopolitical perspective, the concept of liberal democracy is at risk. We should not downplay the significance of this. Putin claims his objective was to push back NATO but it appears he is achieving the exact opposite. NATO members’ resolve is now stronger than ever. Will Ukraine be admitted into the EU on a fast-track basis? I don’t know but it’s possible. One of the counterarguments under consideration is that the level of corruption in Ukraine would be viewed as incompatible with Western European standards. According to Transparency.org, Ukraine ranks 122/180 on their Corruption Perception Index.

Another question worth asking: Do Russia and China grow closer or do they part ways?  Early indication is that the Chinese government is not keen on this war and the hope is that they will use their influence to help broker a ceasefire. My friend, Prof Kerry Brown of King’s College London, shares his thoughts here.

Finally, if Russian troops are stationed near NATO troops going forward, what happens to the equity risk premium (the premium equity attracts over bonds)? Does that decrease?

Special topics:

 

How have the commodity markets reacted?

Commodity prices have jumped higher after sanctions were imposed on Russia. Crude oil surpassed $100 a barrel, aluminium prices touched an all-time high, and gold breached $1,900 per ounce.

Russia contributes significantly to global energy supply. It is estimated that Russia exports about 5m barrels of oil per day, and more than half of that goes to Europe. More specifically, around 250K barrels of Russian oil exports pass through Ukraine every day to supply Hungary, Slovakia and the Czech Republic, according to the International Energy Agency. Russia is also the second largest producer of natural gas after the US, and a leading player in other commodities ranging from coal to precious metals.

Some analysts are forecasting that oil could rally up to $130 a barrel on geopolitical uncertainty. This feels aggressive but probable. On the flipside, countries such as the US and Japan could release supply from their strategic reserves. There is also the wild card of a potential deal with Iran which could help increase supply and moderate the price. 

 

How does this play into the inflation story?

Ukraine and Russia are often referred to as the breadbaskets of Europe. If Ukraine is offline, we should expect an impact on some food prices. In addition, as energy prices increase (natural gas for heating requirements for example), headline inflation rates will incorporate those rises.  

This is compounded by the existing rise in material costs experienced during COVID. Given that inflationary pressure was already building pre-conflict, central banks cannot ignore it. We discuss this at greater length and our positioning in the conclusion.

 

Can this derail the economic recovery post-COVID?

A rise in energy, food and raw material prices will certainly have a real impact on economic activity as it could eat into household spending and knock confidence. But the backdrop remains favourable as financing conditions are good, employment markets improve (US Feb ADP report was +475K more jobs whilst the unemployment rate is expected to register at 3.8%), and consumers remain underleveraged. Further, house prices are strong, corporate cash flows are in good shape and banks are in a much stronger position than before the GFC.  

 

Will blocking Russian banks from the SWIFT network be effective?

I will let the hedge fund manager Bill Ackman respond (as he did on Twitter last weekend):

“I wouldn’t want to keep money in a bank that can’t access the SWIFT system. Once a bank can’t transfer or receive funds from other banks, its solvency can be at risk. If I were Russian, I would take my money out now. Bank runs could begin in Russia on Monday.”

 

Why is this situation so risky?

There is probably nobody left within Putin’s inner circle to present the alternative view. 

Will we be buying direct Russia assets in discretionary portfolios?

No, absolutely not.

Actions taken by the Investment Committee:

 

The voting members of the IC have been in constant dialogue, and we collectively took the view that central banks will probably turn less hawkish over the next month. This means financial conditions continue to tighten (rates rise and quantitative easing reduces) but slower than expected.

As a result, longer duration assets, such as US tech, could potentially experience a bit of a relief rally. It’s for that reason we slowly increased our position in US technology shares this week, on the grounds that central banks going forward will be less aggressive than they would have been had the invasion not taken place. This asset class has been one of the most beaten up this year due to the previously expected wave of central bank tightening.

It’s true inflation is high, and the markets are awash with liquidity. But monetary policy is as much about financial stability as price stability, although that’s not what it says on the tin. Thankfully we raised a little bit of cash during our last IC meeting before the invasion, which gives us some resources to carefully top up. After this action we will be back in a position of being modestly overweight equities. 

We also decided to retain our thematic exposures in energy, commodities, and financials, and FX positioning with a leaning in favour of sterling.

 

Please contact us if you have questions or would like to discuss your portfolio.

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Author -

Gregory Perdon

Gregory Perdon

Co-Chief Investment Officer, Arbuthnot Latham

gregoryperdon@arbuthnot.co.uk

+44 (0)20 7012 2522

Gregory Perdon has served as Arbuthnot Latham’s Co-Chief Investment Officer since 2011. He is Co-Chair of the Investment Committee, specialising in managing global cross asset mandates. He is also responsible for the firm’s Thematic Investment Research. He is regularly quoted in the financial press, guest hosts on Bloomberg Radio & TV and frequently serves as moderator, panellist or speaker at investment conferences in the UK and abroad. Gregory started his career at Oppenheimer after graduating from the American University of Paris in 1997.

Married, with four children, he enjoys raising funds for charities by climbing 4000m mountains in the Alps. Gregory holds both French and American passports, is a Chartered member of CISI and was named by Citywire as one of the Top 100 most influential wealth managers in the UK.

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