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the impact on the financial markets

*This content is brought to you by Overberg Asset Management

By Nick Downing*

The full-scale Russian invasion caught most political analysts by surprise. The consensus was that Putin would do anything to get concessions from NATO. When the invasion began on February 24, most analysts believed the war would be over very quickly. They were wrong again, and wrong about the severity of the sanctions and the extent of the private sector’s self-sanctions. Putin himself must have been surprised by the breadth of international opposition and disappointed by his military’s slow progress.

Nick Downing

Who would have thought that Switzerland would give up its sacred neutrality to join the united front against Putin’s actions? Given the dire humanitarian costs, fighting Putin’s regime is encouraging, but it also means the prospects are becoming more uncertain, and the less Putin gets his way, the more dangerous he becomes.

The humanitarian costs are enormous, especially for the civilian population. Unless the war spreads geographically, the direct economic costs will be limited to Russia and Ukraine. The two economies are relatively small. Russia ranks 13th in the world in terms of its GDP, while Ukraine ranks 57th. Russia accounts for just 4% of euro area exports and less than 1% and 0.5% of UK and US exports respectively. Indirectly, the impact of government and self-sanctions due to rising oil, gas, industrial and agricultural commodity prices is far greater. Rising energy and commodity prices will mean that inflation, which is already a problem for central banks, will increase even more, which will slow household spending and drive up production costs for companies. Central banks, which were on track to tighten monetary policy, will now be more dovish given the war’s impact on economic growth.

How will the war between Russia and Ukraine affect the financial markets? The impact will vary by region. The Russian market will suffer the most, reflecting the severity of the sanctions, including being banned from the SWIFT payment system and sanctioning the Central Bank of Russia, meaning it will not be able to access its foreign exchange reserves. Central bank sanctions have so far only targeted North Korea, Venezuela and Iran and have never ended well. Russia has ordered its banks to prevent foreigners from trading in Russian securities. Russia’s MOEX stock index has been closed since the invasion, but declines in Russia’s global depository receipts suggest the market has slumped 80% since the invasion began. The market is now trading at a trailing price-earnings multiple of less than 1x. However, depending on how the war ends, Russia could be excluded from global equity indices such as the MSCI World Index, and global investors will avoid the market for ESG reasons. Investors should therefore not assume that the index will recover strongly as it did in 2014 after the Crimean invasion.

US and Asia-Pacific equities will be the least directly affected by the crisis. Europe is most at risk because of its dependence on Russian oil and gas. Around 25% of European oil and 40% of gas requirements are covered by Russian supplies. Europe’s banks are also most exposed to Russia. Great Britain is also affected due to its proximity, although not as severely as the euro area. Europe will face the greatest cost from the flood of Ukrainian refugees, already numbering over 2 million according to United Nations estimates, most of whom are destined for European countries. For investors, however, these heightened risks have a silver lining. The ECB will be more cautious than other central banks in rolling back pandemic-era monetary stimulus. Governments in the region are also likely to resume pandemic-era fiscal stimulus to cushion the economic impact of the crisis.

When Russia invaded Crimea in 2014, emerging markets were hardest hit. The outlook is very different now, especially for commodity dependent economies like South Africa. The unexpected storm of raw materials in the state budget in the 2022 financial year is well on the way to being repeated in the current financial year. Emerging market currencies are generally undervalued. EM central banks are ahead of their developed market counterparts in raising interest rates to counter rising inflation, and EM local currency bond yields are already trading at wide spreads compared to US Treasuries, making them less vulnerable to global risk aversion are.

There is considerable uncertainty about the extent and duration of the military crisis in Ukraine. Unless the conflict spreads across the Ukrainian border, however, the impact on global financial markets is likely to be short-lived. Unfortunately, it is a fact of human life that wars and crises occur regularly. According to precedent, stock markets suffer in the first few weeks of a war, but then gradually recover. The worst market setback since World War II, caused by military conflict, occurred during the first Gulf War in 1991. Global stock markets fell 15-20%. However, they recovered quickly. This time may be different, but investors should be careful not to be too negative. A ceasefire or peace agreement could easily lead to a stock market rally.

Investors should not forget that before war broke out, global economic momentum was extremely positive, helped by a slowdown in the Covid pandemic, above-average GDP and earnings growth, and healthy household and corporate balance sheets. Financial markets have not been complacent in pricing the risks posed by the Ukraine crisis, as evidenced by the sharp falls in share prices over the past two weeks. The global market’s trailing price-to-earnings multiple is now down 16.5x from its peak of 20x last year. The less demanding valuation significantly improves the long-term return prospects. While markets in the US remain expensive compared to their historical average, they currently offer compelling value in the UK, Europe, Japan, China and emerging markets. Meanwhile, corporate credit spreads, the proverbial ‘canary in the coal mine’, continue to perform well, reflecting the lack of contagion from global financial risks.

Investors must avoid knee-jerk reactions to the current crisis. Portfolios should ideally have been structured in advance to mitigate the risk of worst-case scenarios through diversification across asset classes, currencies and geographic regions. Investors will be eager to do something, but the trade that adds the most to portfolios over the long term is buying, not selling at the current low levels. It is certainly still too early, but the time will come when the worsening of the crisis abates.

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*Nick Downing is CEO and Chief Investment Officer, Director of Overberg Asset Management

  • All opinions of the authors are their own and do not constitute investment recommendations or financial advice. Consultation with a qualified wealth and investment professional is critical before making any financial decisions.
  • ‘Overberg Asset Management (Pty) Ltd. is an authorized financial service provider: 783’

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