Q&A Russia-Ukraine: impact on financial markets

There have been several sanctions now. At the beginning, it seemed that the European Union (EU) and the US were focussing only on the private and financial environment of Putin and the oligarchs (a small group of powerful Russians who are able to influence politics). But with further military escalation, also trade and financial sanctions were imposed, which have directly impacted prices and economic activity. Oil, gas, palladium and wheat prices surged Monday morning, resulting in a price shock, which is leading to inflation and a slowdown in economic activity - especially if the war is to persist for a longer period or to escalate even further. As long as the price shock is more of a short-term event, markets and economy should be able to deal with it. In addition, there will be fiscal stimulus and monetary support to reduce the impact of the external price shock (see question 4).

The new trade and financial sanctions will create financial instability in Russia itself, as the Russian ruble is depreciating, creating a risk of a bank run. Also the Swift sanction, which is blocking money transfers between Russian banks and financial institutions in other countries, has a direct impact on Russia. As EU exports towards Russia are limited, direct economic impact in EU is limited.

Yet, risk is rising that there will be a supply shock, in case Russia is to respond with blocking commodity exports, either as a reaction on sanctions or because payments are not processed due to the Swift sanctions. To avoid the latter, not all Russian banks are blocked.

In a historic perspective, wars have always had limited effect on equity markets, even wars with direct impact on oil prices. Since 1945, market reaction was on average flat after one month. An exception was the Gulf War in 1990, after which the S&P 500 was down 8%.

Within discretionary portfolios, we are not investing in Russian or Ukrainian bonds directly. There is, however, limited indirect exposure via investment funds as Russia and Ukraine are part of the emerging markets bond index. The exposure is limited to approximately 0.2% to 0.3% of the overall portfolio, in line with the benchmark exposure. This is also the case for the advisory model portfolios, with an exposure between 0.2% and 0.33%.

Ukraine has in the past received a supporting package from the International Monetary Fund (IMF) and the EU. We understood that this support will remain. The Russian bond market will face a new reality, with the new sanctions on the Russian national central bank and a downgrade of its credit rating to non-investment grade (junk) status by Standard & Poors, one of the rating agencies.

Even though it is too soon to make solid statements, it is clear that these investments are now fully at risk as the future of Ukraine and Russia’s willingness and ability to repay any debt are at stake.

Overall, this geopolitical crisis is negative for cyclical sectors. It could feed, albeit temporary, an economic slowdown - in particular in Europe - through a confidence shock and a price shock with the increase in commodities prices. We expect the US economy will be impacted by the price shock too, especially if it lasts longer, but less than Europe. Banks could also underperform in the short term, as risk-off conditions are generally negative for this sector. It is, for example, unsure whether all outstanding loans can be repaid in full.

On the other side of the spectrum, we think defensive sectors such as consumer staples or health care will outperform, as investors are looking for visibility on earnings. The energy sector could continue outperforming due to an increase in energy prices. However, this sector could be also exposed to specific risks that are rising due to the western sanctions against Russia. Companies with exposure to Russia are expected to underperform their peers.

During the last weeks, we have made changes in our sector allocation. It has become more defensive by increasing the sectors energy and consumer staples to neutral and by decreasing industry to underweight and consumer discretionary to neutral. For the time being, we hold on to our overweight positioning in financials, considering a relief rally could occur in case of de-escalation.

All major central banks, especially the US Fed, were on the path of interest rate hikes, given the high inflation and strong growth. A price shock, with the strong rise in oil and gas prices, could lead to lower economic activity and at the same time drive inflation even higher than the already elevated levels¹. Worse would be a supply shock that could be a result of Russia blocking exports to the West. This would be a problem especially for Europe, which is heavily relying on Russian energy imports. In both cases, economic growth would suffer - even a recession is possible - and inflation will overshoot and stay elevated. This could lead to stagflation, characterised by slow growth and high inflation.

In such a stagflation scenario, the European central bank (ECB) is bound. Rising rates would drag economic growth even further down and would not cushion an external supply shock. It is, therefore, more likely that the ECB will focus on the growth aspect, as a price shock will grow out after some time. Also weaker demand will lower inflationary pressure. In the current situation, this could mean that the ECB would stop normalising its monetary policy and stay expansionary. Another possibility is a more joint approach of fiscal and monetary policy, which we saw after the corona outbreak. Governments could lower taxes on energy or provide support and help to mitigate the inflationary effect.

In the US, the situation is different. As long as the current crisis does not lead to a serious impact on global and US growth, we do not expect the Fed to change its policy. We still expect several rate hikes this year and the beginning of a wind-down of the central bank balance sheet. Inflation in the US is more driven by the tight labour market. As long as economic growth is not seriously affected, we expect the Fed would to stay on its current course.

_{1 See also: https://www.abnamro.com/research/en/our-research/russia-ukraine-macro-economic-implications}

The European economy is clearly most exposed to the Russian-Ukrainian war. On the downside, in the short term, economic growth in European countries is going to slow given the temporary confidence shock and an increase in energy prices, predominantly impacting countries that are highly dependant on Russian gas and oil.

On the upside, we see large government expenditures. For example, fiscal stimulus dedicated to build new energy infrastructure in order to increase European independence from Russian oil and gas. And reinforcement of military capacities², as announced for example by the German government. Additionally, the ECB could delay its plan to tighten monetary conditions if necessary.

Consequently, as regional allocation is always a relative game, for now we prefer not to over-react and to keep our neutral stance on Europe. The EU is with a price/earnings ratio of 14 more attractive regarding valuation than the US market with a ratio of 20. Also, the US is more exposed to growth stocks and could suffer from the Fed tightening in coming quarters.

We would like to emphasise for investors that it is sensible to stay diversified, to invest globally in these times and look through the volatility. For the time being, we expect volatility to remain high during the escalation process. We will monitor closely all positions regarding the impact from the war, the impact from the sanctions and a possible price or supply shock.

_{2 Read more about our investment policy, also regarding weapons.}

Richard de Groot
Chair, ABN AMRO Global Investment Committee