Where is Noah and his ark when you need him! This deluge of rain of biblical proportions hitting the eastern board of Australia, has been unrelenting! We hope that any flood damage has been as minimal as possible for you. We have had several native animals, being a kookaburra, two magpies, and a bandicoot ‘move in’ under the protective roof of our backyard balcony, in a desperate move to get dry and find some safety from the incredible rains and winds. Poor critters.
This natural disaster has arrived just as the remaining Covid-19 restrictions of the past two years have been, in the main, finally removed. Alas, more indoors confinement because of the severe weather, but this will recede, and life will go on. It has been a tough and frustrating couple of years for all, both physically and mentally, with a lot of challenges, changes and inconveniences. In saying that, it does not compare to the unjustified destruction and personal misery that the Ukrainians are being subjected to by the madness of the invading Russians. Although the ‘conflict’ will hopefully end soon either outright or via a valid ‘truce’, the Ukrainians can and will rebuild. However, the cost to Russia of the serious imposition by the world with the deserved and severe sanctions against Russia, not to mention the reputational damage to Russia, will be enormous. Russia (certainly Putin should) will be asking itself, why did we do this in the first place. Its people, its economy will suffer immeasurably, and its self-isolation caused by ostracisation, will be crippling.
Given the present high focus on the geo-political events in the Ukraine and given the negative impact on global markets from concerns of this, whether real or just fear, I have included below a couple of current articles detailing some succinct commentary on the situation and its likely impact ahead.
Nevertheless, as disciplined long-term investors, we must bear in mind the strength of underlying economic fundamentals that preceded this Ukrainian conflict have not gone away, but just appear partially absorbed and ignored by the noise and fears of this geo-political event. We should not become distracted by such, but rather see it as an opportunity to build our quality investments, and income streams.
The first related article, is from JP Morgan Asset Management, ‘On the Minds of Investors’ about the Russian/Ukraine conflict. Below are key points from its paper:
- “Energy prices face asymmetric risks as tight demand/supply balance would keep prices elevated, even if tension de-escalates.
- Indirect impact on growth from high oil prices should be manageable and prompt central banks to temper their hawkish stance.
- Despite the fluid geopolitical situation, we expect investor focus to return to global growth fundamentals and policy. Avoid sharp knee-jerk swing in allocation”.
“As the events in Ukraine continue to unfold, this note seeks to answer the economic and market questions from investors around the world.
How will the crisis affect global energy prices? Russia accounts for 13% of global oil production and 17% of global natural gas production. However, the European Union’s (EU’s) reliance on Russian energy sources is far greater: around a quarter of EU crude oil imports and 40% of natural gas imports currently come from Russia. There is only limited scope for the EU to offset any disruption in supply by accelerating imports from other sources, and recent price swings have been exacerbated by the fact that EU energy stocks started winter at depleted levels after an unusually cold autumn. Sanctions imposed to date have been designed to minimise the impact on energy supply, but energy prices will remain highly sensitive to further developments.
The risk to energy prices is asymmetric. We could see significant moves higher in the event that concerns around supply disruption worsen. If the situation calms, we would expect energy prices to decline but the tight supply/demand balance in the market is likely to keep prices at elevated levels relative to history. There are other possible sources of supply that may help to restore demand and supply balance in the long run. This includes sanctions against Iran being lifted if the nuclear agreement is restored, release of global strategic reserves and an increase in production capacity by other oil-producing countries, including the U.S. However, this would still take time and would be unable to address the short-term disruptions.
Will central banks have to hike more rapidly in the face of higher commodity-driven inflation? In our opinion, no. We expect central banks to prioritise growth and thus see central banks normalising policy more gradually as they acknowledge the downside risk that higher commodity prices present to growth. Market pricing for a 50-basis-point hike from the Federal Reserve (Fed) and the Bank of England (BoE) at their next meeting (in mid-March) has fallen to 20%, whereas in previous weeks it had been as high as 80%. (The most likely outcome Market pricing for policy rates by the end of the year has also fallen, with investors now expecting at least one fewer hike from both the Fed and the BoE than they did a few weeks ago.
For Asian central banks, the urgency to follow the Fed was low before the Ukraine crisis. Inflation in the region is manageable and many Asian economies are still at an early stage of pandemic recovery. The latest rise in commodity prices should reinforce their cautious tone.
Which regions are more vulnerable? The European economy is the most exposed given its high dependency on Russian energy. We see the extreme scenario where Russia cuts off all gas supplies as unlikely given the effects it would have on Russia’s income. Europe’s banking system is also exposed. But according to the Bank for International Settlements the total exposure is USD 89billion, which appears manageable. Our judgment is also that the European Central Bank (ECB) has the most scope to slow the pace of monetary tightening because wage pressures are less acute, which should cushion economic activity and spreads in the periphery.
The U.S. consumer can be sensitive to rising gasoline prices, but the oil and gas sector tends to benefit from increased activity. The U.S. became a significant net exporter of energy in 2019, so periods of higher oil prices are not as detrimental to activity as we saw historically.
In the emerging world, there are winners and losers. Commodity exporters (such as Australia) are benefitting from higher prices. However, unlike in the developed world, central banks may be forced to tighten policy in the face of rising inflation which would slow activity. There is therefore a significant dispersion of market performance amongst emerging market (EM) benchmarks.
Investment implications: Historically, geopolitical events, even those involving major energy producers, have not had a lasting impact on markets. Looking back at equity market sell-offs relating to geopolitical events, they have tended to be short and sharp, with sell-offs not lasting much longer than a month as markets react to the sudden event. The size of the market reaction can be considerable, as it has been in this instance, with equities sometimes falling more than 10%. But in most previous geopolitical incidents, markets have tended to recover to their prior levels in under a month, after investors assess that the macro environment has not materially changed. Of course, if the growth backdrop has materially changed, as it did with the 1973 oil shock, then it can lead to a more material sell-off and a longer period to recover losses.
One thing does seem abundantly clear: in the short term and long term, we expect the crisis to intensify the investment in the transition towards renewables as higher energy prices and fears of energy security add to existing climate concerns”.
The second related article, is from MFS Investment Management, ‘Russian Invasion Fuels Market Volatility’, and some other macro items. Below are key points from its paper:-
“With the humanitarian crisis resulting from Russia’s invasion of Ukraine growing, we wish to express our sincere concern and support for the people of Ukraine and our hopes for a swift de-escalation of hostilities and a peaceful restoration of the country’s national sovereignty.
Russia- has been isolated from the global financial system.
Sanctions imposed by Western governments in response to the invasion took hold this week, including the planned cut-off of seven Russian banks from SWIFT, the communications system that facilitates global money transfers. Additionally, foreign currency reserves held by the Central Bank of Russia have been frozen, limiting its ability to support a weakening rouble. Index providers MSCI and FTSE Russell announced on Wednesday that they will remove Russian equities from all their indices, effective next week. MSCI is changing its classification of Russia from an emerging market to a standalone market. According to Reuters, the country had a weighting of just over 3% in the MSCI emerging market index and about 0.3% of its global benchmark. This week, credit rating agencies S&P, Fitch and Moody’s each downgraded Russia’s sovereign rating, putting it in the high-yield category. S&P, after the second downgrade in a week, rates the country just two notches above default. The agencies said Western sanctions call into question Russia’s ability to service its debt. In retaliation for the sanctions, Russia announced capital controls that will block coupon payments to foreign owners of Russian bonds.
Commodity prices soar.
Since the start of the invasion, the broad Goldman Sachs Commodity index is up about 16%, to a 14-year high. Oil futures breached $115 a barrel this week for the first time since 2008 as sanctions limited market access to Russian raw materials. Russia has been forced to offer steep discounts on its crude but is still having trouble finding buyers. To the extent that dollar-denominated export revenues become unusable or illiquid, Russia could see less of an incentive to sell energy to the West, analysts at Goldman Sachs said this week. Oil prices eased from their highs on Thursday amid reports that Western nations are close to a deal with Iran over its nuclear program. The recent widespread surge in commodity prices and disruption of existing supply chains is exacerbating already high global inflation. One outgrowth of the sanctions is fear that higher global natural gas prices will push up the costs of fertilizers, ultimately resulting in food price inflation and shortages.
Germany, others, undertake major policy shifts in defense and energy.
The German government’s announcement that it will dramatically increase defense spending in response to national security threats posed by Russia is expected to help offset some of the economic drag stemming from higher energy prices. Shortly after the invasion, German Chancellor Olaf Scholz laid out a number of major policy shifts, including halting the approval of the Nord Stream 2 gas pipeline from Russia while announcing the construction of two terminals to allow for the importation of liquified natural gas. Scholz also announced Germany will build a strategic natural gas reserve to reduce the country’s reliance on Russian gas supplies. In addition, the German chancellor floated the once-heretical idea of extending the life of several coal- and nuclear-fired power plants. Germany is not alone in reacting strongly to Russia’s attack on Ukraine. Switzerland broke with its centuries-old policy of neutrality, sanctioning Russia, while Sweden and Finland are said to be considering joining NATO. Sweden parted ways with tradition by exporting 5,000 antitank weapons to Ukraine, an active combat zone, this week. Meanwhile, Ukraine has applied to the European Union for immediate membership.
Putin-allied oligarchs feel the pinch.
The US, EU and United Kingdom are ramping up pressure on Russian oligarchs closely allied with Russian President Vladimir Putin. Many were sanctioned after Russia’s seizure of Crimea in 2014, and sanctions have been stiffened in the wake of the invasion of Ukraine. Several yachts and other properties have been seized, and trophy assets such as the Chelsea Football Club have been put on the market.
OTHER MACRO NEWS
Powell signals that the Fed will hike rates a quarter-point.
In testimony on Capitol Hill this week, US Federal Reserve Chair Jerome Powell indicated that he is inclined to propose and support a 0.25% increase in the federal funds target when the FOMC meets March 15 and 16. “The bottom line is that we will proceed, but we will proceed carefully as we learn more about the implications of the Ukraine war for the economy,” Powell said, but added that if inflation stays hot, the Fed would be prepared to raise rates more than 0.25% per meeting. It is too soon to assess the impacts of Western sanctions on Russia on the US economy, the Fed chair said. North of the border, the Bank of Canada began its tightening cycle on Wednesday, raising its policy rate to 0.5% from 0.25%. Multiple additional hikes are expected.
Despite eurozone inflation soaring to a record 5.8% in February, markets have lowered expectations for multiple rate hikes from the European Central Bank this year.
Fears of slower economic growth as a result of surging energy prices and the fallout from sanctions on Russia combined to push the yield on the benchmark 10-year German bund back into negative territory this week. Bund yields peaked at 0.33% in mid-February, prior to Russia’s attack, in anticipation of tighter ECB policy. US rates have fallen as well amid the highest bond market volatility since the early days of the pandemic. Markets forecast the Fed will now tighten slightly less aggressively than before the invasion”.
Disclaimer for information provided in this Commentary: This document, and the information contained within, is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, or plan feature. The views expressed in this are subject to change at any time. No forecasts are or can be guaranteed.