From Russia with Love

Mar 3, 2022 | News

“You can do a lot more with weapons and politeness than just politeness.” Vladimir Putin

Who would have imagined I would be writing an article about the impacts of a WAR in Europe! The Russian invasion of Ukraine constitutes the most significant war in Continental Europe since World War II.

While human interest promotes a focus on short-term headlines, the ongoing conflict will have important longer term geopolitical implications. Popular notions that liberal democracy is decadent and in decline now need recalibration, as Europe’s democracies are invigorated and have a clarity and unity which was absent before this war. To reiterate, we maintain our current asset allocations including a neutral equal weight (E/W) allocation to equities. Investors should seek ways to provide portfolio diversification with respect to this geopolitical crisis.

Headlines have been dominated by the Russian invasion of Ukraine. Global equities rebounded from intraday lows despite the escalation of Russia-Ukraine tensions, as the USA and the European Union (EU) ejected Russia from the SWIFT global payments system. Global markets experienced heightened volatility on Monday, as investors priced in the impact of SWIFT sanctions on Russian banks. The EU and its allies are also preparing to impose sanctions on the Central Bank of Russia.

Globally, central banks will now stand ready to provide liquidity when required, as the exclusion of Russian lenders from SWIFT may lead to missed payments and huge overdrafts within the international banking system.  This will spur monetary authorities to reactivate daily operations to supply the market with US dollars – absolutely vital.

At home, Putin is paying a high economic price for his war. A wall of western sanctions targeting Russian banks, companies and individuals led to a collapse in the ruble (RUB) and prompted the central bank to impose capital controls to allay investor panic. In response to the European Union’s (EU) actions, Russia has also shut its airspace to airlines from 36 countries. In addition, Russia has prohibited Russian residents from conducting foreign currency transactions. As the RUB fell 26% against the USD to 105.30, Russia’s central bank increased its key policy rate from 9.5% to 20% to attract deposits. Not a pleasant outcome for ordinary Russians.

Market reaction saw the Bloomberg’s 60/40 model index — which tracks the returns for a classic diversified portfolio of 60% stocks and the rest in bonds — is down about 9% this year, putting it on track to exceed the 11% plunge recorded during the pandemic. In cryptocurrencies, Bitcoin slid to around $35,000 amid risk aversion and the second-largest token – Ether – also suffered heavy losses.

Some analysts have raised their near-term oil price forecast to $110 from $100. The events in Ukraine have introduced a risk premium in oil prices that is likely to remain in coming months. This, against a backdrop of market tightness, means even small disruptions can have large price impacts. However, a new study has found that the EU could make it through next winter without new imports of Russian natural gas.

As Russia’s economy is caught in the closing vice of unprecedented global sanctions, Putin’s televised order that his nuclear forces assume a heightened alert status has been getting ever more scrutiny. Bill Browder, a decade old opponent of Putin and intimately aware as to what makes Putin the man, said that it’s not inconceivable to him that Putin would set off a nuclear bomb if it was his best chance of staying in power – maybe not in the short term, but possibly in the medium term.

This scrutiny must speak to the character of the man Putin whilst perceived as religious and an imperialist.  According to Bill Browder, the founder and CEO of Hermitage Capital Management, author of Red Notice and architect of the Magnitsky Act. “Vladimir Putin is a liar and a con man,” said Browder. “He’s (Putin) never told the truth once in his life; and everything he says or does has an ulterior purpose. I don’t think that Vladimir Putin has an ideology. I don’t think he cares about the Soviet Union. I don’t think he cares about NATO.”

Russia’s deepening economic ties with China could help mitigate the impact of sanctions on its exports as they can use China’s Cross-Border Interbank Payment System (CIPS) to settle trade with China. However, the escalation of the war will prompt Chinese reassessment on multiple fronts. Potential economic risks are Russia’s central bank and private sector have almost $1 trillion of liquid wealth, with a much larger share than most people realise held in US dollars.  This is even after the country sold all its Treasury holdings in 2018 and is enough to disrupt money markets if frozen by sanctions. It raises the potential of a sanction-proof economy that can disrupt money markets.

Also, Russia and Ukraine are major grain exporters.  Russia is also rich in energy and metals – in particular palladium, platinum, nickel, and rare gases. Supply disruptions could stoke already-high price pressures just as the Federal Reserve prepares to tighten policy however, analysts believe that the Russia-Ukraine war may not alter the course of Fed policymaking at all.

In summary, NATO will likely deploy more troops in Eastern Europe and a new Cold War will likely follow. How the Russia-Ukraine war evolves in the coming months will test Putin’s political future and Russia’s geopolitical standing in Europe. The severe penalties on the Russian economy and the ensuing recession will have a limited direct impact on the global economy. In most cases, the economic impact on countries beyond Russia and Ukraine is likely to be limited but the Russian invasion will have long-term ramifications. And, for now, it looks like the impact of the Russia-Ukraine war on world trade will be small in aggregate. But the hit would become much larger if energy trade with Russia were cut off. And there is also a chance that Western sanctions will worsen bottlenecks – and hence dent trade – in other goods, such as autos.

The sanctions on Russia will benefit some emerging market (EM) countries and EM currency resilience has been impressive throughout the Russia-Ukraine crisis and the US stock market shakeout. Trailing and forward P/Es are at 13.5 and 11 for EM stocks, while they are 25 and 20 for US equities respectively, and on a look through appear attractive. So, maintain current asset allocations, including a neutral E/W allocation to equities.

The direct impacts on SA exposure are that SA gas prices now reference off these global benchmarks, holding meaningful implications for both industrial consumers and Sasol as the major supplier. Glencor will also see some impact with oil via EN+ (Anglo-Russian green energy company) but will see offsets via their commodity trading desk. Nepi, Steinhoff, Mondi, and Barloworld – all exposed operationally to Eastern Europe and/or Russia – came under pressure. As did Prosus and Naspers, with an investment in Mail.RU (Russian Internet Company), although this makes up a very small part of their investments. Investors should seek ways to provide portfolio diversification with respect to this geopolitical crisis.  Please chat to your Trust Officer should you need to do so.