Aegon IM summarises impact of Russia’s invasion of Ukraine on the markets

Colin Dryburgh, Investment Manager, Multi-Asset & Solutions at Aegon AM, outlines the potential market impact of Russia’s invasion of Ukraine.

The headlines that Russia has begun a full-scale invasion of Ukraine have sent financial markets into acute risk-off mode. Equity markets fell sharply, oil prices jumped above $100/ barrel and government bond yields declined.  Markets had already been impacted by escalating Russia/Ukraine tensions, but the latest news clearly elevates the risk of a severe and prolonged conflict. The end point is unknown.

Russia is a major supplier of oil, gas and other commodities to the rest of the world.  Also, Ukraine is a major supplier of grains and fertilizers.  The combined Russian and Ukraine economies are less than two percent of world GDP, so non-energy and commodity-related impacts on the global economy and financial markets should be limited.  The transmission mechanism from this conflict to western economies and markets is therefore via its impact on energy and commodity flows and prices. This occurs at a time when commodity prices are already elevated.

The near-term economic and financial consequences of current events will be meaningfully impacted by the West’s response in terms of further sanctions on Russia.  To-date sanctions have been targeted at specific Russian financial institutions and individuals.  Germany has also halted the process of certifying the controversial Nord Stream 2 gas pipeline that is intended to double the amount of gas flowing from Russia to Germany and bypass the traditional route via Ukraine.

Russia would financially suffer if sanctions limited its ability to export commodities.  This could happen either directly or indirectly, by blocking Russia from international payments systems.  However, Russia has been preparing for such an eventuality by accumulating large foreign exchange reserves and working on an alternative payment system with China.

Europe, and Germany in particular, are highly dependent on Russian gas to heat people’s homes, power industry and generate electricity.  Last year the EU imported more than 40% of its gas consumption from Russia.  A German business magazine cover recently summarised the situation as: Vladimir Putin controls Germany the way a dealer controls a junkie. Natural gas is the drug of choice.

Despite the large human and geopolitical implications of this crisis, western politicians and societies may not have the stomach for energy shortages combined with prices that are even higher than today’s already elevated levels.  Higher energy costs are effectively a tax on consumption and could lead to recession.  Should the west’s response not involve significant economic self-harm then financial markets may well reverse some of the recent extreme moves that have occurred.

Irrespective of how this situation develops in the weeks and months ahead, policy makers face new and increasingly difficult choices.  Accelerate the build out of renewable energy to lessen dependence on energy supply from politically unstable regions, or backtrack on the phase out of nuclear and dirtier forms of power generation?  How to militarily respond to a Russia that may in the future have its sights set on other countries in the region, including NATO members?  Expansionary fiscal policies to soften the blow of higher energy costs?  Do central banks tighten more than planned due to the inflationary consequences of higher energy prices or less due to likely weaker economic growth?

Whilst we all hope that the short-term volatility being seen comes to an end because of what that implies on the ground in Ukraine – although we have little insight into this and will need to watch events and the responses to events closely.  Longer term the size of the energy shock and the potential persistence to it is a development of concern and will significantly impact policy settings, growth rates and consumer and institutional investment intentions away from paths that look established just a month ago.

Below are some asset class-specific comments.

Sovereign bonds

In sovereign bond markets we have seen an immediate drop of interest rates as investors moved towards safe haven assets. Investors are now even more worried about the prospect of higher inflation due to the rising oil and gas prices and the potential for other shortages due to future sanctions. As a result, we have seen a further rise of inflation expectations, which pushed the yields on inflation linked bonds down more in comparison with nominal bonds. This crisis might postpone the plans for monetary tightening by central banks, but with inflation numbers to remain high for quite some time, we do expect the trend of tighter monetary policy to continue. In our funds we have a neutral duration position, with an overweight of inflation linked bonds. Within periphery we are slightly overweight in Spain and Portugal, while being slightly underweight in Italy. We hold an underweight in French government bonds and are overweight agencies, especially bonds issued by the EU.

Credit

In credit markets the trend of widening credit spreads continues after the news of the Russian military actions. From a sector perspective the European banks with exposures to Russia and Ukraine (like Raiffeisen Bank and Unicredito) saw most credit spread widening, while in the energy sector companies with significant exposure to Nordstream 2 (like Wintershall) are hurt. In the last few months, we have already positioned our credit portfolios more defensively, mostly in anticipation of tighter monetary policy and decreased central bank support. We expect the current crisis to push spreads wider and keep our defensive bias until we see a clear improvement in market sentiment.

Equities

Our equity allocations have minimal direct exposure to Russia.  The ongoing style rotation out of growth/ quality and into value/ cyclicals (other than oil) could well be challenged by the above-mentioned weaker growth implications of higher energy prices that act as a tax on consumption.

Currency

Currency markets have experienced an unusually low amount of volatility given the recent pick-up in volatility in other asset classes.  Typical safe-haven currencies, such as the Japanese yen, are well positioned to perform strongly in the current environment.  Emerging market currencies whose economies are highly dependent on energy and food imports will likely suffer due to the disproportionate impact that they will incur from higher commodity prices.

Sources:

Gas exports figure:

https://www.politico.eu/article/putin-russia-intends-to-continue-supplying-gas/#:~:text=In%202020%2C%2035%20percent%20of,alone%2C%20not%20including%20LNG%20shipments.

German magazine quote:

https://www.ft.com/content/dc77ae83-15fc-481a-8f52-9184068e6a56