Russian sanctions: assessing the damage and contagion risks
While it can seem wrong to focus on financial markets when bombs are dropping on Ukraine’s main cities and children are dying, the reality is that when tanks roll into a city, not only are they harbingers of physical destruction, but of financial destruction too. Likewise, the sanctions that the West have imposed on Russia are a declaration of financial war, and this will have reverberations outside of Moscow. While brave journalists and foreign correspondents keep you updated with the geopolitical developments, we will attempt to keep you informed of the market and economic consequences, of which there are many. Below, we list our top five things to consider.
1, The inflation risks
By far the biggest threat to the global economy is from the rise in energy prices. We would note that, so far, there have been no sanctions on energy exports from Russia, which is good news for Europe that receives 40% of its natural gas from the country. However, some politicians are of the view that politics and standing up to the thuggish Putin regime is more important than economic fundamentals right now, and Canada – an oil rich nation – is going to ban imports of Russian oil. Do not expect Europe to follow suit, as its energy reliance is much more focussed on Russia than Canada and the US. The Russia/ Ukraine war is already adding to high levels of global inflation, the Fed’s preferred measure of inflation, the PCE index, rose to 5.2% from a year ago in January, which is the highest level since April 1983. Including food and energy prices, prices rose by 6.1% YoY, the highest level since 1982. Brent crude surged passed $100 per barrel once again on Monday, as the markets digested the latest round of sanctions on Russia, with some commodity analysts now expecting to the oil price to reach $115 in the coming weeks. However, we would point out that the oil price is not yet in panic mode. For example, brent crude closed the US session below the $100 threshold, as investors looked towards the outcome of the talks between Russian and Ukrainian officials on Monday night. So, while it can be tempting to distil market action down to sell tech and buy energy, price action on Monday showed that it may not work for short term traders. For example, some of the oil majors have been forced to get rid of their joint ventures with Russian oil firms. BP could take a hit of up to $25bn if it writes off its entire stake in Rosneft. We think that this is unlikely, instead it will need to write off $11bn in its foreign currency assets linked to the company – it can’t remove this money from Russia at the moment due to sanctions and some Russian banks being denied Swift access. It could then value its stake at $14bn, in the hope that someone will buy it. We think that this is unlikely, as you will see below, the market for Russian assets has practically frozen, which is reflected in the decline in BP’s share price on Monday. Although commodity prices are surging, BP’s share price was down nearly 4% in after-hours trading on Monday. However, on balance we expect BP’s share price to recover in the coming weeks, by offloading its stake in Rosneft it has dramatically reduced the political risks of doing business with Russia. The divestment of Rosneft will also accelerate BP’s move away from oil and gas, which could help its long-term share price.
2, Contagion effects
Global sanctions against Russia are a declaration of financial war on Russia by the West. The closure of the Russian stock market and the sharp decline in the Ruble on Monday, along with the inability to trade most Russian assets, highlights how liquidity can evaporate from financial markets in the blink of an eye. The price of Russian debt is now at distressed levels. The crazy thing about this is that prior to Russia’s invasion of Ukraine, Moscow had an incredibly low debt-to-GDP ratio of just over 20%, however, because of these sanctions, Russia now faces defaulting on its obligations. This is not down to fundamentals – it has the money – but down to compliance – the money can’t leave Russia or Russian banks and pay international bond holders. In terms of global exposure to Russian assets, exposure to Russian equities and the Ruble is fairly limited, however, some European banks have sizeable exposure to Russian debt and foreign currency denominated loans. For example, French and Italian banks have exposure of $25bn each, with Austrian banks exposed to the tune of $17bn. Thus, a Russian default has global consequences, if a default happens then these banks will have serious holes in their balance sheets which may limit their abilities to do business at home. This is why European bank stocks took a beating on Monday, with Deutsche Bank down more than 5%, UniCredit down nearly 10%, and SocGen also down nearly 10%. Expect more pain for banks globally as we wait to see if Russia’s central bank has any swap lines with other banks to avert a financial default. Russia’s central bank also doubled its bank rate to 20% on Monday, which was a sign that it wanted to instil confidence in its domestic banking system and entreat Russian savers not to trigger a bank run. This is an extraordinary move, which if it fails to cause a reduction in queues for ATMS across Russia, could lead to further capital controls from the central bank in the coming days.
Other areas of contagion include aviation leasing companies with aircraft in Russia, private schools in the UK and other parts of Europe and a rising risk of cyber-attacks, which could target the West’s largest and most vulnerable sectors like health services and banks.
3, Assets that are set to outperform
It is not all bad news for risky assets, stocks that tend to have low levels of volatility are in demand right now. That includes consumer staples, defence names and some energy stocks. In the US, McDonalds share price rose in post-market trading on Monday, likewise defence names like Lockheed Martin and Northrop Grumman rose by 5.95% and 7.9% respectively on Monday, although there are signs that these stocks could give back some of their gains on Tuesday as markets recoup some of their losses at the start of a new month.
4, The silver lining
There are two potential silver linings from recent price action linked to the war between Ukraine and Russia. The first is that there has been a dovish realignment of Fed policy. The market had expected US interest rates to reach 1.7% by year end earlier in February, but by the end of the month that had fallen to 1.4%. The 2-year Treasury yield has backed down to 1.43% from a high above 1.6% earlier this month, the 10-year yield is also back at 1.82%. Traders are not expecting the Fed to hike interest rates by 50 basis points when it meets in March, instead there is a 91% chance of a 25 bp hike, which is a more moderate pace that should be appreciated by risky assets and limit further downside in the coming days and weeks.
Secondly, could high energy prices provide supportive flows to equities from oil rich sovereign wealth funds, which are benefitting from the surge in the oil price? We shall have to see, but my intuition tells me the answer is yes.
5, Are we close to the end game?
The answer to this question is that we don’t know. However, when you see such sharp moves, for example the decline in the Ruble on Monday, the retail traders instinct can be to take the other side of this trade, or the contrarian position. But not this time. the Ruble is very hard to trade right now, and there is unlikely to be a meaningful recovery until Putin is out, either out of the Ukraine, which we think is unlikely, or he is out of office with a peaceful transfer of power to one of his more moderate inner circle. A nuclear option in this war is still a possibility, but it is one that is too dreadful to consider in humanitarian terms let alone try to price in by financial markets. However, for as long as this conflict lasts, then the prospect of a nuclear attack from Russia rises, which is why there could be more volatility for equity markets ahead. This is also why traders should continue to have a short-term mindset and fade market rallies in the coming days until the future becomes clearer or we reach a “new normal” with this conflict.