Heading towards a new Cold War?

After denying having any expansionist views on Ukraine, Vladimir Putin decided to intervene militarily in Ukraine on 24 February 2022. Only two days after recognizing the separatist republics of Donbas, the Russian invasion began and at present time Russian troops are circling Kyiv. In such dramatic circumstances, our first thoughts and sympathy go to the Ukrainian populations already hard hit by this conflict.

Fund Commentary
3 Mar 2022

After denying having any expansionist views on Ukraine, Vladimir Putin decided to intervene militarily in Ukraine on 24 February 2022. Only two days after recognizing the separatist republics of Donbas, the Russian invasion began and at present time Russian troops are circling Kyiv. In such dramatic circumstances, our first thoughts and sympathy go to the Ukrainian populations already hard hit by this conflict.

A weak economic impact but significant and localized sectoral impacts

The economic weight of Russia and Ukraine remains relatively limited on a global scale, with respectively less than 2% and 0.2% of world GDP. With 2.5% of the European Union’s trade, Russia is only the 15th largest trading partner of the European Union (EU) and the 5th largest outside of intra-EU trade.

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It is true that rate hikes seem to be very ineffective weapons against a supply shock, at the risk of seeing inflationary issues take hold for a long period.

On the other hand, Europe, led by Germany, is Russia’s leading trading partner, accounting for 36.5% of its imports and 42% of its exports. This co-dependence explains why, if Russian assets were the first and most strongly affected (-33% for the Russian MOEX Index on 24/2 alone), European markets are also impacted but to a lesser extent. Unsurprisingly, European stocks with a Russian nexus (cars, commodities, energy, banks) are suffering the most, especially after this weekend and the decision was taken to selectively cut the access to the Swift payment system for Russian financial institutions.

Table 1: Major Commodities – Russia and Ukraine’s importance

Wheat Ukraine and Russia account for 29% of global exports.
Corn Ukraine is among the world’s top 4 exporters with 4.5 million tonnes per month.
Gas Russia is the major gas supplier of Europe with 45% of its gas imports.
Oil With 10.5 million barrels per day, Russia is the world’s 3rd largest producer and a key supplier to Europe (25% of its oil imports).
Gold The world’s 3rd largest producer and accounts for 10% of global mine production.
Palladium World’s largest producer with 2.6 million ounces, 40% of global mine production.
Platinum 640,000 oz production, 10% of total mine production.
Titanium Russia produces 27,000 tonnes and Ukraine 5,400 tonnes, equivalent to 15% of the global total.
Nickel 7% of global mine production.
Aluminium 6% of total world production.

Source: Reuters, Banque Eric Sturdza.

The risk of a commodity supply shock

It is in the commodities sector that a supply shock is most to fear, given the importance of Russia and Ukraine to a lesser extent in global supply (see Table 1 above). First and foremost, energy markets could be the most at risk: with nearly 10.5 million barrels/day, Russia is the world’s 3rd largest producer and is only 2nd to the US for natural gas.

A possible total or partial loss of Russian production would be a major issue at a time when the balance in energy markets is pretty tight with rebounding demand post-COVID and a supply-constrained (OPEC+ production quotas, lack of investment, energy transition). It is no coincidence that the first sanctions spared the Russian energy complex, which is both the major supply channel for some European countries and Russia’s main source of revenue.

Table 2: Geopolitical Events and S&P 500 Performances

Source: Banque Eric Sturdza.

Despite the tense situation, the relatively light sanctions on this front at this stage and the likelihood floated by the United States to tap into its strategic reserves have allowed the conflagration on the commodity markets to be limited so far. This crisis has the merit of forcing strategic reflections in Europe (energy independence, common defence), a reflection already largely underway in the United Kingdom and France, but complicated for Germany, dependent on Russian gas for half of its gas imports and which, for lack of a gas terminal, cannot hope to substitute it with LNG in the immediate future.

What happens next?

Geopolitical crises are sadly not rare and isolated events. With hindsight, an analysis of the impact of these events on the financial markets over the last 70 years highlights several points:

  1. The market impact is generally negative when the event occurs.
  2. The impact is limited and performances tend to turn positive a few months later.
  3. The main exceptions to the rule concern events that degenerated into a recessionary oil shock. The reaction of the US market, which ended in positive territory on 24/2, may have been a surprise but should be analysed in the light of the context of increased pressure to raise short-term rates and reduce the size of the balance sheet…

Indeed, with the resurgence of geopolitical risk, the Fed has an excuse to be less hawkish. In Europe, the prospects of the first-rate hike in 2022 already seem far away. It is true that rate hikes seem to be a very ineffective weapon against a supply shock, at the risk of seeing the inflationary pressures take hold.

The Russian invasion is reshuffling the deck: yes, monetary tightening could temporarily take a back seat, yes, the inflationary problem could persist in the event of a supply shock, yes, certain themes will have to be revisited in light of the new geopolitical realities, and yes, diversification remains a must, between safe havens and selective repositioning on quality assets already too severely punished.

 

Fixed-Income Markets: TINA bullied by the ECB

Hawks back in command in Frankfurt

The European Central Bank has taken the markets by surprise by abruptly turning its back on its hitherto ultra-accommodating attitude. The German Bund has not only returned to positive territory but was around 0.30% before the Russian invasion.

The ECB cannot afford its so-called more restrictive policy and it is illusory to believe in a rate hike as early as 2022. This return of the Bund to positive territory did not succeed in distracting us from the major event of this month of February: the US 30-year real rate has also risen above 0% but the consequences of such a movement are out of all proportion to that of the German 10-year.

Real long rates are oxygen for other markets and when they rise, oxygen becomes scarce. Wall Street should therefore expect to breathe more heavily…

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Hybrid corporate debt has undergone a very severe correction, offering investment opportunities that are only slightly less attractive than in March 2020, at the height of the COVID crisis.

Backpedalling to minimise the impact of a failed ECB meeting, Christine Lagarde emphasized that rate hikes in the current environment would have more drawbacks than benefits and would not solve the current problem of soaring prices. Perhaps the message will be heard by the Fed, which must now avoid a major monetary policy error, synonymous with a possible recession in twelve to twenty-four months.

The end of TINA?

TINA – There Is No Alternative, to equities of course – may be on its way out. Dollar-denominated investment grade credit spreads have widened significantly and are already offering interesting investment opportunities. It is now relatively easy to build a diversified portfolio with a reasonable duration and a yield above the dividend yield of US equities.

In the euro market, the change is even more obvious since the ECB’s turnaround. Many investment-grade credits have returned to positive yields and the hybrid credit market has undergone a very severe correction that offers investment opportunities only slightly less attractive than in March 2020, at the height of the COVID crisis. Subordinated bank debt also offers good prospects. Italian corporates are also an option, “thanks” to the ECB’s ambiguous attitude.

It has been a long time since we have had such an embarrassment of riches in the euro fixed income market. The Russian military intervention in Ukraine reminds us that geopolitical risk is also present. All the more reason to add a small amount of 30-year US Treasury bonds to a portfolio in homeopathic doses. Long-bond is a safe haven par excellence that protects against crises of all kinds. The US yield curve is flattening day by day: the message is clear!

 

Equity Markets: Should investors become more optimistic when markets are not?

While February initially welcomed a rebound of equities from January lows, geopolitics entered the fray with fresh uncertainty around a Ukrainian conflict sparking an additional move down. As of the time of writing, the situation has dramatically escalated with Russian troops advancing on Kyiv, and additional rounds of sanctions, likely severe, are being prepared. The thought of war at our doorstep is sobering, and before we dryly discuss market implications, let us underscore the human toll this development represents.

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The Ukrainian invasion is injecting fresh volatility in a market already grappling with previously discussed challenges of inflation, monetary policy, and commodity shortages. As always in financial markets, the lingering question is: are the risks now priced in?

Warren Buffett, the renowned “Oracle of Omaha”, famously quipped that “investors should be fearful when others are greedy, and greedy when others are fearful”. Easier said than done, as the vast literature on market psychology demonstrates.

It is nonetheless critical to reflect on this wisdom, especially when the plausibility of negative scenarios has seemingly increased in the market’s collective psyche. In this process, a key is to recognize three main elements: the anticipatory nature of financial markets, the probabilistic nature of these anticipations, and the asymmetry between risk and reward appetite.

Another historical precept for equity investors, “buy the rumour and sell the news”, succinctly encapsulate these points by reminding participants of the great lengths with which markets reflect public information by adjusting gradually to the possibility of an event materializing, and then leaves little additional gains to be had once the scenario is realized. Natural human risk aversion, the tendency to place a higher weight on avoiding a given percentage loss compared to an equal potential gain, further helps explain the tendency of markets to exhibit lower volatility going up than down – in plain English, the tendency for markets to move sharply as risks increases while ascending more gently when encouraging news circulates.

In practice, this implies that bad days are larger in variation but are less frequent, and thus phases of corrections can be intense but tend to be short-lived, requiring the successful investors to turn optimistic more quickly in times of volatility. The Ukrainian invasion is injecting fresh volatility in a market already grappling with previously discussed challenges of inflation, monetary policy, and commodity shortages.

The US market’s intraday reaction on February 24th was a case in point, with the S&P ending in positive territory after an initial drop. No doubt, the diminishing probability of an aggressive hiking cycle given extraordinary geopolitical tensions alleviated pressure on growth stocks in a “bad news is good news” manner.

But more importantly to our point, it suggests once more that the market had already been anticipating the increased probability of deterioration over the preceding weeks, and that risk-aversion had pushed many investors to prepare for a conservative, or “worst” outcome.

How can investors apply these fundamental tenets in today’s market is always a challenge of course, but separating risk into known and unknown can offer a path. Today, much of the challenges posed by the Ukrainian conflict and the inflation/monetary policy situation allows for a multitude of scenarios, a number of them detrimental to equities. But what are the market’s expectations today?

Markets are never immune to potential “black swans”, or unknown unknowns. However, investors can take some comfort in finding that the market is currently fearful, responsive and sensitive to the known risks. Does the current environment qualify for a Buffetian contrarian view on equities? At this point, we believe investors have strong reasons to, at the very least, not succumb to any panic, and stay the course.

Graph 1: AAII Investor Survey – Bullish vs. Bearish Readings

Heading towards a new Cold War?

Source: AAII, Banque Eric Sturdza.

As can be seen from the AAII investor sentiment readings, not only are allocators concerned, it is increasingly hard to find any remaining bulls. Even with a certain degree of caveat emptor, the current levels suggest significant risk-aversion priced in the market with pessimistic readings comparable to previous lows in the market. In essence, data does suggest that known risks are heavily reflected in current prices.

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolios.

Adam TurbervilleAdam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements contained herein are those of Banque Eric Sturdza SA as of 01/03/2022 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.