What has happened?
The Global markets have processed a lot over these first two months of 2022. The establishment of high inflation and an anticipated interest rake hike have kept investors on their toes.
The risk of the Russia/Ukraine conflict turning into a full-fledged war has become reality. The prospect of war had seemed low as the Russian President, Vladimir Putin, had repeatedly stated that Russia had no intention to invade Ukraine. He wanted security guarantees from the West, and he does not want Ukraine to become part of the NATO (North Atlantic Treaty Organization) Alliance.
Although it seemed that diplomacy would avail, on the 24th of February 2022, Russia recognized the two separatists backed regimes in Eastern Ukraine as independent entities and immediately advanced its military forces on Ukraine. Putin pushed out the narrative that Russia is carrying out a “special military operation” to ‘demilitarize’ Ukraine, blaming the current government for planning a “genocide” in eastern Ukraine.
What is happening?
The World saw through the false narrative and understood that Putin’s ultimate plan behind the invasion of Ukraine was to dismantle the current democratic government and install a “puppet government.” His play is to keep the “puppet government” from becoming a part of NATO which would thus keep the “threat” from Western Countries at bay while creating a buffer zone between Russia and the NATO countries.
Having previously experienced the retaliation of the Western World on its misadventures in the neighbouring regions; Russia had expected a blunt round of sanctions and had prepared in advance by building up its foreign exchange and gold reserves to ~$630 billion and dramatically reducing its holdings of US treasuries in 2018 (see chart). Russia also strategically reduced its gas exports to Europe to a minimum in Q42021 which depleted gas inventories and exacerbated the energy crisis in Europe. Europe depends on Russia for about half of its natural gas imports. Putin believed this would serve as a deterrent to imposing effective sanctions against Russia.
Source: Bloomberg, as of March 2, 2022
In our view, Russia seemed to be planning this operation well in advance and had expected to quickly take Ukraine and succeed in its power move.
As the World watches, the advance appears to have not gone according to Russia’s plan. The Ukrainians have shown remarkable grit to defend their homeland and are putting up stiff resistance to Russian advances. The stories emerging from Ukraine have made the Democratic World realize that this is a war for democratic values which brought the Western governments to enact effective sanctions on Russia. Sanctions include:
banning Russian banks access to SWIFT (Society for Worldwide Interbank Financial Telecommunication)
banning transactions with the Russian Central Bank
Switzerland broke from the tradition of remaining neutral and decided to implement all sanctions imposed by EU
Several companies are halting operations and severing ties with Russia.
These measures have inflicted heavy economic pain on the Russian economy. Russians are lining up at ATMs to withdraw cash, the Russian currency has lost about 30% of its value against the USD, the Russian Central Bank was forced to increase interest rates to 20% from 9.5% and an estimated $400 billion of the $630 billion in foreign exchange reserves have been frozen.
What is likely to happen?
We think it is unlikely that Russia will back down from its aggression any time soon as such a move will mean losing face to its domestic audience and portraying weakness to the Western World. The fact that only the deputy ministerial level delegation from the Russian side was present during the negotiations with Ukraine implies that the probability of a resolution is minimal. It is likely that the war is going to continue longer than expected as Ukrainian soldiers fight side by side with civilians who have picked up arms to help defend their country. Even if Russia dismantles the military infrastructure and installs a “puppet government” in Ukraine, it will be costly for it to maintain the status as the Ukrainian people will continue to rebel.
Ukraine’s application to be a member of the European Union is currently under consideration. Ukraine had also submitted its bid to be a part of NATO in 2008 and has been on the path to meet its requirements. In our view, this provides sufficient ground to believe that the tensions between Russia and NATO in the coming years will stay elevated.
The economic fallout and the implications for risk assets
The Covid-19 pandemic exposed the fragility of global supply chains and highlighted the need to move towards independence from interdependence in key areas. The Ukrainian/Russian conflict has brought energy security discussion to the front as Europe is dependent on Russia for about half of its natural gas imports. As companies and countries rethink their supply chains, this will lead to increased costs and inflationary pressures. Crude oil, natural gas, aluminum, and wheat are some of the commodities that have been directly impacted by this war and have seen their prices appreciate.
Russia’s already weak economy will now have to bear the fallout of severe sanctions and the cost of funding this war will further strain its economy. However, given that it constitutes only 3% of global GDP, the overall impact on global growth will be minimal.
Nevertheless, upward pressures to already high inflation put together with elevated geopolitical risks and the start of an interest rate hike cycle, indicate the backdrop remains challenging for risk assets in the near-term. Historically, the impact of such regional geopolitical events on markets has been rather limited and lasted for only short-term. This should be the case this time too as we expect the conflict to remain confined in Ukraine.
In our view, we believe managing high inflation and risking interest rates is relevant in our planning. We believe it is best managed by staying well diversified and overweighting areas that tend to do well during such periods. This includes a preference for ‘value style’ over ‘growth style’ investments, a preference for companies with high pricing power, and a preference for companies leveraged to higher commodity prices.
We acknowledge there is a slim chance of this conflict spilling out of Ukraine, in which case the geopolitical risk will increase dramatically and would warrant an increase in allocation to cash. Your Team at O’Farrell Wealth & Estate Planning is closely monitoring the evolving situation and will advise accordingly if it becomes necessary.