Ukraine crisis - Financial markets update from LGT Vestra

March 2022

We are just over a week since Vladimir Putin instigated the invasion of Ukraine. We feel great sadness for the people of Ukraine and the families of all those that have lost their lives as a result. The world had hoped that a peaceful solution was possible until Putin ordered the troops to cross the border, triggering a huge humanitarian crisis as millions flee the fighting. Putin may have expected a walkover but was in fact faced with protests and stiff military opposition. After the initial sanctions were imposed, they may have believed that Europe would not risk damaging its own economy, however this belief has been disabused too.

As I write, the fighting continues and talks have so far been about humanitarian corridors and a temporary ceasefire, rather than an end to the hostilities. We may accept that the overwhelming superiority of fire power possessed by Russia is likely to gain more territory on the ground, but this will come at a huge cost on both sides. For Russia, any win on the ground may prove to be a Pyrrhic victory for Putin, with massive economic consequences at home. With great sadness for the people of Ukraine weighing on our hearts, we must be dispassionate when we look at the consequences for investors and consider the impact on their portfolios.

A fluctuating impact

Markets this year have been through three distinct phases. For the first three weeks, markets were driven by fears of rising inflation and interest rates, before results season commenced and reminded us that it is company earnings that, ultimately, drive returns. There was a huge dispersion of returns between companies, but markets overall seemed to find some composure. Meanwhile, tensions rose between Russia and Ukraine as forces moved to the Ukrainian border and on 11th February, President Biden warned that an invasion of Ukraine was imminent. Since then, markets have focused on news out of Ukraine.

As tensions escalated in the build-up to the war, markets sold off, spiking lower as the invasion started on 24th February. On that day, European markets and US futures spiked lower than recovered as the US trading day took over. There was initial relief for investors that sanctions were not tougher, then over the weekend much more punitive sanctions were announced, with the freezing of the Russian central bank’s assets and many Russian banks cut off from the SWIFT international payments system. Russian exports of oil and gas have so far not been sanctioned specifically, but supplies have been reduced and Russia is finding it hard to sell its oil. Oil and gas prices soared, and intraday moves have been large. On Thursday, Brent crude futures were at one point close to $120, before dropping back to as low as $109.4. As I write this morning (Friday 4th March), they are trading around $111 which is up from $95 on 11th February, and $78 at year end.

What does this mean for commodities?

Ukraine is the breadbasket of Europe. If the war is prolonged and this year’s crop fails, then there will be a huge shortage of wheat and other agricultural commodities. Russia is an exporter of fertiliser and if supplies are cut, it may reduce crops elsewhere. Grain futures rose steeply and the wheat future for May this year has risen 50% since 11th February.

Commodity price rises and supply disruptions will add to inflation which was already high. Food and heating are essential spending and rising costs may constrain the consumer’s ability to spend on other products. The inflation spike is likely to be extended, but growth may be constrained and, in the long run as supplies normalise, inflation may be expected to fall back. Central banks will be balancing their wish to tighten, to counter inflation with a wish not to do more damage to growth. Earlier in February, the market moved to price in a total of seven 0.25% rate rises this year with a possibility of a 0.5% rate rise in March. While inflation expectations have risen, the expected rate rises priced in have come down to six. Speaking this week, Federal Reserve’s Chair Powell said that he favoured 0.25% in March, but did not rule out a faster pace later in the year. US bonds on the back of this and as a result of a flight to safety have rallied with the 10-year yield down to 1.8% (from a high of 2.05% in mid-February).

Exposure to Russia

We are frequently being asked what our exposure to Russia is. While we may have little exposure to Russia directly even when we look through funds, many companies do have exposure to the Russian market. As an obvious example, BP owned a stake in Rosneft, and Renault owns Lada, but many other companies have operations or sales in Russia. Almost all portfolios have some indirect exposure - the impact of which is more varied and harder to measure. Many companies have closed Russian operations or said they will dispose of Russian assets. Rouble has dropped 30% and so has the MOEX index of Russian stocks. The stock exchange has stopped trading and Russia has banned foreign investors from selling stocks. In practise, disposing of interests in Russia may be difficult.

Falls in the currency and sanctions are causing hardship for many Russian citizens. Meanwhile, oligarchs who have supported Putin are having assets seized and their ability to travel curtailed. It is to be hoped that domestic pressures will cause a change of heart in the Kremlin, but this may take time. For now, very sadly, the bloodshed will continue, and the flow of refugees will be unabated.

We need to be wary of knee-jerk reactions to events. The initial reaction to the war saw markets marked sharply lower across the board. The US Technology heavy Nasdaq index closed on Thursday 7% above the intraday low on the day of the invasion. The US market and the tech sector in particular may be less sensitive to events in Russia than Europe. Banks had benefitted this year from the expected higher rates, but those with exposure to Russia have been hit hard. Raiffeisen Bank, based in Austria and with big exposure in Eastern Europe, saw its share price drop over 50% since mid-February. Oil companies have done well, backed by higher oil prices, but those with exposure to Russia have underperformed more recently.

Conclusion

It is a complex situation but, since the invasion, the US market, which is more domestic and higher in technology, has outperformed. The rise in the dollar has also helped these exposures for Sterling and Euro-based investors. Equity markets look cheap relative to bond interest rates reflecting the risks. Equity markets can be volatile but investors who are prepared to take the risk have been rewarded.

The S&P 500 index has returned an average of 6% since 1930, with dividends that rise to 9.7% through depressions wars and financial crises. With inflation averaging 3.1% (US CPI), this is a very healthy real return. When times seem blackest, it has often turned out to be the right time to buy, even if hardest to do so. Perhaps the bleakest moment in my lifetime came on 22nd October 1962, when President Kennedy announced that they were blockading Cuba to prevent Russian missiles being placed there. The threat of nuclear war and the end of the world as we knew it was very real. The crisis continued until 28th October when Khrushchev conceded. However, if you bought the S&P 500 the day after Kennedy’s announcement you would have timed the bottom of the market and made over 20% in the next three months.

As we saw in the oil market on Friday, we are seeing big intraday movements in both directions. We cannot predict daily or hourly movements and caution against trying to trade the moves. However, we also continue to suggest that those who hold cash and are looking to average in continue to do so.