Monday digest

Posted 7 March 2022

Overview: a double-edged sword for investors as sanctions take hold
As the economic consequences of Russia’s invasion of Ukraine begin to unfold, the impacts of the war on global financial assets have also changed in nature. Last week saw tougher sanctions imposed by the European Union (EU), US and UK on an almost daily basis. This drip-feed inevitably resulted in equity market weakness. Moreover, Russian equities and bonds have not only seen their values plummet, the inability to trade them at any price has impacted broader emerging market mutual funds and exchange-traded funds (ETFs).

One difficult aspect of these economic effects has been the interplay between sanctions on Russian banks and energy and commodity markets, which has contributed to another surge in global oil and European gas prices. European utility companies are not (yet) barred from buying Russian oil and gas. However, they have difficulty in paying for it in the normal way. Rebuilding these payment channels will take time. If businesses are still able to buy Russian energy, authorities must ensure financial channels are open to make those purchases. Moreover, companies need reasonable reassurance that energy sourcing sanctions won’t be put in place later, and will need protection from other reputational risks.

The other aspect prompting last week’s equity market weakness was the more downbeat growth outlook. It’s fair to say investors have substantially downgraded real growth estimates for this year amid greater inflation pressures. The epicentre has been Europe, but the rise in energy costs means the US is also affected. Bond markets are telling a similar story. In particular, the yields on inflation-linked bonds have headed down sharply as increased demand for safe haven assets has encouraged bond prices to soar. These bond moves also may be telling us that central banks could look through the current input cost-push inflation and keep monetary policy accommodative for the time being, thereby allowing elevated levels of inflation persist for longer. In his testimony to Congress, US Federal Reserve (Fed) chair Jay Powell said interest rates will likely go up 0.25% on 16 March, less than the 0.5% almost universally expected two weeks ago. Even Friday’s strong US employment numbers (with the US economy adding 678,000 jobs in February) failed to push up fixed coupon yields.

In such difficult times, is there any hope? We believe there is. While most of the damage is to Europe’s growth estimates, impetus from the EU’s Next Generation Fund will continue through this year and next, come what may. Also, the massive increase in defence spending by the German government will also come through quickly. Defence spending has a large ‘multiplier’ effect – the spending being recycled round the economy. Looking out beyond 2022, growth could be shifted up to a higher, not lower, level over the next few years. Much depends on energy costs and how long they remain elevated. While the de-coupling of bond yields to oil prices is heartening, it would be good to see the Brent crude spot price fall back from over $120 per barrel to a more manageable level well below $100. Ultimately, when risks are obvious and emotions are running at a high level, markets will overshoot the downside at some point. Of course, it’s difficult to know when that is. Meanwhile, the strategy of  remaining calm and waiting for the market to cool off has usually proved beneficial, and we think it probably still is.

China’s enduring partnership with Russia feels the strain
As horror unfurls in Ukraine, and sanctions wreak havoc on Russia’s financial infrastructure, China could be the key to any resolution. But for Beijing, the war in Ukraine is a hugely complicated issue. Officially, China has always maintained a threefold position: Ukraine is a sovereign territory, Russia has legitimate security concerns over the expansion of NATO, and negotiation is the best solution. This goes hand-in-hand with the Chinese Communist Party’s longstanding approach to international relations, which emphasises national sovereignty, opposes the US-dominated global order and pursues diplomacy over military engagement.

Last week, as tanks rolled across the border and Russian firms were booted out of western equity markets, the general media view was that the Russia-China partnership would become stronger. However, this narrative is contentious. With several big Russian banks now banned from the SWIFT payment system, it is thought that China’s rival CIPS system will become more important for Russia-China trade. Indeed, this displacement was one of the reasons European politicians were hesitant to ban Russia from SWIFT, and investors seem to agree, judging from the rally in Chinese payment infrastructure companies. But there are barriers to this shift: CIPS currently still relies on SWIFT for cross-border messaging, and in any case, it will be a long and costly transition for Russian banks.

Even ignoring the economic aspect, the strategic partnership looks much weaker than it did a month ago. In the short term, China is still struggling, with the collapse of Evergrande Property Group causing pain in the housing market, and Beijing’s zero-Covid policy forcing the country into a series of lockdowns. The Chinese government has recently loosened monetary and fiscal policy in a bid to bolster domestic demand, but officials are well aware that export growth is vital to sustained growth. For all the talk of “no limits” cooperation, China’s economic ties to Moscow are relatively thin, and anything that harms US or European trade is at odds with Beijing’s growth focus.

The long-term picture is more complicated. The Chinese government has shown many times it is willing to sacrifice short-term economic growth for longer-term political gain. If Beijing sees this as a way to undermine the US-led global order, it would not hesitate to support Russia. The fact that is has been so hesitant therefore indicates that the longer-term benefits are unclear. That said, there is a real potential for Beijing to emerge from this crisis looking strong on the world stage, particularly should it play a role in mediation as reports have suggested. This seems to be the view in currency markets, where the Renminbi has been remarkably stable, despite havoc for many other emerging market currencies. China’s currency is becoming increasingly important in global trade and could remain so whether it chooses to support Russia or not. For now, Beijing continues to push a line of neutrality, but that may not be tenable for much longer.

Emerging market investors worry about their exposures
The financial fallout from Russia’s invasion of Ukraine has made life difficult for emerging market (EM) investors. After sweeping sanctions and asset seizures, Russia’s equity market entered a nosedive. That led to Moscow slamming its trading halls shut last Friday, and they have stayed shut since. EM funds with exposure to Russia are therefore under pressure to sell down their positions, but market closures make this very difficult. For ETFs tracking broad EM indices, there is an increased risk of outflows or even suspensions should Russian assets remain part of the index.

Russia’s weighting within broad EM indices is small, due to the growth performance of other regions, most notably China, which alone accounts for over a third of the MSCI EM equity index. Still, bad ingredients spoil the pot. Keeping Russian assets in the index is not a viable option for most funds, as those shares are simply uninvestable. MSCI and FTSE Russell have already announced the removal of Russian assets in one go, effective from 9 March.

With removals and trading bans, there is no easy way for tracker funds to handle any Russian assets held. It may be of small comfort to investors, but this is a consequence of passive investing, and situations like this are part of the risks of investment. This is particularly true for EMs, where political instability is always a key factor in valuations. Fund managers are essentially at the whim of index providers if they deem certain assets unacceptable for investment, and are no longer able to assess the value of underlying investments. Some index tracker funds have announced that Russian holdings will now be valued at zero following their index removal. Fund managers really have little choice. Either they value their Russian assets at zero and keep trading, but risk harm to their clients, or they wait to get a fair market price for those assets. The problem with the latter is that there is currently no market for Russian assets, and without a price on underlying assets, the entire fund cannot be traded. As such, zero valuations are probably more prudent than the ‘wait-and-see’ approach, even if it means missing out on some value from the underlying holdings.