Last week I wrote that the Western response to the Russian recognition of two breakaway republics had been very mild, perhaps because it stopped just short of a full invasion. As we all know that full invasion has since commenced and the more vigorous response from the West has denoted that this is, as expected, unacceptable.
This turn of events has widened the permutation of outcomes and merits further analysis and commentary.
Please note my comments will concentrate on the economic and financial market implications rather than moral or military aspects of the conflict.
Over the weekend the West has imposed financial sanctions that, despite being better structured to cope than it was in 2014-15, will have a severe impact on the Russian economy. The major sanctions are the banning of c. 70% of the Russian banking industry from using the SWIFT payments system and preventing the Central Bank from accessing all of its foreign reserves. Additionally, Russian aircraft have been prevented from flying over European airspace.
The Russian currency collapsed, the stock market closed, and this morning the Russian Central Bank was forced to more than double interest rates to 20% from 9.5%.
In another seismic geopolitical shift, Germany has given notice of its plan to spend an extra €100billion on defence and to finally increase its defence spending to the NATO prescribed 2% of GDP. As very few NATO members excluding the US and UK actually do this, expect a broad increase in NATO members increasing their defence spending to 2% of GDP. Spending in such a manner has historically added to inflationary pressures.
The scenarios that could unfold are as follows:
1. Putin admits his mistake and does a volte-face (odds incredibly long)
2. A face saving compromise is reached with Ukraine and the West (more likely but not a slam dunk)
3. A war of attrition ensues a la Afghanistan and Chechnya (odds between one and two above)
4. All-out war (very unlikely but alas still lower odds than scenario one)
We then need to assess how much more conflict will ensue before a potential compromise is reached and also how will sanctions build until that point. This is a vital assessment as the short-term impacts are already huge on Russia, could become huge throughout Europe and given the importance of Russia and Ukraine to commodity supplies, the global impact could be significant too.
Russia’s plan for a lightning military strike to meet little resistance and thus be over in a couple of days is already obsolete. Although this will probably be a huge annoyance to Putin, he has overwhelming military strength versus Ukraine should he demand a military victory at all costs.
The question then becomes whether Russia or Europe can bear the most pain should oil and gas become a part of the equation i.e. can Russia do without energy revenue longer than Europe can do without the utility of energy. There will be no economic winners here, it’s a question of who loses least.
It is likely Putin will threaten European supplies but actually withdrawing them is a huge gamble given how big a part of both exports and government revenues the sector constitutes (the Russian government receives c. 10% of its revenue from energy companies).
Europe is already suffering from hyper energy inflation and the crises will only exacerbate and extend the situation. The UK is far less exposed to Russian energy and the US is practically self-sufficient in hydrocarbons and thus relatively immune from the fallout. China has been very lukewarm in its support of Russia but will stand to gain more leverage should it become the buyer of last resort for Russian exports.
So in the short-term high commodity prices look set to continue and business and consumer confidence are set to be shaken by both geopolitical events and high inflation.
Europe seems to be on the worst end of both as well as being most exposed to further deterioration in the outlook.
As mentioned in my first update last week the more dramatic interest rate increases are likely off the table for now and this will provide some support for financial markets. Indeed, financial markets have been incredibly resilient this last week with UK and US indices barely changed whilst vulnerable European Indices have contained losses to low single digits, as has Japan. The more pronounced losses in Hong Kong are more to do with regulation of technology companies than Ukraine. In what should be a time of flight to safety government bonds have made only very modest headway with yields falling around 10 basis points in the US and Germany and much less in UK. Safe haven currencies such as the US Dollar and Yen have both advanced by over 1% since last Monday when Putin made his declaration. We should note that most equity markets had already been under pressure on concerns about monetary policy tightening.
There is still pent up demand, especially in services, in most parts of the world with Europe actually well positioned in this respect. Combined with excess consumer savings and higher government spending (including defence spending) this should prevent a recession on the Continent in all but the worst case scenarios.
At WH Ireland, most central models only have between 5 and 6.5% direct exposure to European Equities so the fallout has so far been relatively well contained. We have far bigger exposure to both the UK and Asia.
Equity markets around the world are well off their highs and Russian exposure via financial and trade links have been reduced by most Western countries since they invaded Crimea in 2014, e.g. European exports to Russia equate to only 0.7% of EU GDP.
Therefore opportunities will arise and we will strive to take advantage of them in a risk controlled manner. Preservation of capital remains our utmost priority, as such we will invest where there are the most attractive risk rewards, not just where we see the most absolute upside should everything go right. There is not likely to be a shortage of options in the period ahead.
Chief Investment Officer