Equities were sharply lower across the globe following Russia’s attack on Ukraine. However, early falls in the US on Thursday were reversed mid-session and indices actually moved higher.
So, what is actually happening?
Most share markets today are around 10-15% below recent peaks. Traditional safe havens such as the US dollar and government bonds have rallied. Substantial economic sanctions on Russia from Europe, the United States, Australia with other allies are certain to follow. The consequences of a protracted conflict in Ukraine are still largely unknown.
The geopolitical implications of this attack are complex, and the timing unfortunate. Russia is taking advantage of a moment in history when the US:
- is embroiled in a bitter competition with China;
- has an unpopular and a perceived weak president in Joe Biden
- has a divided and soon to be Republican-dominated Congress.
Furthermore, the US has suffered an embarrassing and poorly executed withdrawal from Afghanistan, and clearly the US population has little appetite for further overseas wars.
However, in this context it is worth noting that the world and investment markets have already seen and continue to observe the de facto takeover of Hong Kong by China. Whilst it has not been as dramatic in terms of stark TV coverage, it is clear that markets have been fairly positive towards developments in Hong Kong. The point is that we should not fall into the trap of drawing dire conclusions from the Ukraine situation. There may even be reactions to events that change the course towards the positive. We should be concerned but we should not panic. However, we should not ignore the cost to Ukraine and its citizens.
A broad view of the landscape
On top of the political situation, the economic environment is volatile and now even more uncertain.
The global economy is gripped by post-pandemic inflationary pressures – which are higher than they have been for 40years. Major central banks are trying to pivot from abnormally low “emergency” interest rates to move back to more “normal” settings. They are also engaged in plans to reduce the size of their balance sheets by halting the purchasing of government bonds. A misstep, by moving too quickly, may affect debt markets.
Specifically looking at Russia/Ukraine we see that the Russian economy is of similar size to Australia whilst Ukraine’s economy is far smaller. Both are important in energy and food production and distribution. Western Europe imports around 30-40% of its oil and gas needs from the region, and both Russia and Ukraine are significant grain exporters. While questions remain whether oil and gas supplies from Russia will be disrupted, market prices have already soared, as have grain markets.
Importantly, we should remember that Russia is in some senses a failed state. At the height of the Cold War in the 1960s, the Russian economy almost matched that of the USA. Today is one-twelfth (1/12) the size of the US and hence its need for nuclear weaponry, and the world’s third biggest armed forces to stay relevant.
We expect Russia will be ejected from most world forums and its government severely restricted in its capacity to retain an international voice. Arguably, Putin may well have made a significant misstep that will ultimately determine his fate.
To consider the investment implications, we must speculate upon various likely scenarios.
Whilst higher energy and food prices will add considerably to inflationary pressures, there have already been indications that the US will reinvigorate its oil production. A request to Saudi Arabia to increase oil production would not surprise. It is notable that Russia supplied 2% of US oil needs in 2021 as the US cut back production. This will surely change.
Meanwhile, international sanctions and a plunging Russian currency will magnify Russian inflation and risk social unrest. Despite having built up considerable foreign reserves of some $600 billion in recent years, Putin’s Russia doe snot have the capacity to withstand sustained international pressure.
Russian economic implications
Cash yields are at 10% and bond yields are at 14%. Russian corporates will struggle to raise debt and the Russian central bank will be forced to use their reserves and eventually print money. Because the Russian rouble is not a reserve currency, the printing of it could cause hyper-inflation.
Meanwhile the Russian stock market has collapsed:
Developed market implications
Meanwhile, in developed countries, inflation surges will act as a tax on consumers. The move on Ukraine adds to inflation pressure but it could result in checking the potential for aggressive rate increases in the US and Europe.
In any case, the Russian move will affect the sentiment of consumers and businesses alike, and act to slow economic recovery post the pandemic. It is doubtful that this in itself could cause a recession as it will not be matched by sharply rising interest rates.
Russian aggression will (has) affected investor and market sentiment and based on history can be a trigger that creates opportunity. More so if price declines do not reflect the reality of the longer term outlook.
In the shorter term, no one can be certain how or when this situation will resolve itself – and markets hate uncertainty.
A further complication is that many markets are already presenting with high earnings multiples compared with their long term averages. For example, the price earnings ratio of the ASX 200 has averaged around 14.9x historically, and today it is close to 16x. Whilst that is historically high, it does reflect the outlook for a strong economic growth period with low interest rate settings (in Australia).
In the US, the price earnings ratio of the S&P 500 has averaged around 16.1x, and today it trades at around 19x.However, and at the same time, bond yields are still at near historic lows. Indeed, bonds rallied on the announcement of Ukraine hostilities. Bonds, which are already expensive (and ignoring inflation), actually became more expensive whilst giving the illusion of a “safe haven” asset.
That said, there is reason to remain confident about the future in the longer term. Further, the pullback in markets (a correction) has increased the dividend yield on the Australian equity market and increased the potential return from risk assets.
Although markets respond to significant events such as this with some degree of alarm, they often recover within a few months. Nevertheless, short term volatility is likely.
In general terms, the best advice during periods of crisis is to keep a cool head, re-examine your investment objectives and ensure that your asset allocation remains appropriate.
John Abernethy
Chairman, Clime
General Advice Warning
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