European markets opened in the red this week as investors fretted over escalating tensions between Russia and Ukraine. By the close of trading on Monday, the Euro Stoxx 600 was down 2% with the travel and leisure and banking sectors enduring the biggest bruising.
Meanwhile, oil prices touched fresh seven-year highs. Brent crude hit $95 per barrel, leaving analysts speculating it could surge to $100 p/b for the first time since 2014.
“An invasion of Ukraine would likely push oil prices sharply higher, beyond $100 at a time when the market is already in rally mode driven by an imbalance between demand and supply,” says Victoria Scholar, head of investment at Interactive Investor.
Investor confidence plummets in UK and Europe
Hargreaves Lansdown’s index shows investor confidence sentiment down in every sector – with the exception of global emerging markets which was unchanged from the previous month.
The hardest hit was the UK, down 11% between January and February, followed by Europe (-10%).
“Just as the storm of Covid appeared to be receding, the growing expectation of an invasion of Ukraine is the fresh threat now unnerving investors, with confidence plunging in many parts of the world,” says Susannah Streeter, senior investment and markets analyst at Hargreaves.
“With worries that inflation is already running far too hot, the possibility Russia troops could move across the border has led to another surge in the oil price to above $95 a barrel, edging up towards $96, a level Brent crude has not been at since 2014.
“Energy markets are clearly on edge and if supplies are threatened there is a risk oil will shoot up even higher, adding to price pressures for companies.”
Streeter adds: “A fresh surge in European gas prices is also expected if conflict does erupt which would intensify the cost-of-living squeeze and this could temper consumer confidence.”
NATO, nuclear weapons and diplomacy
Diplomatic efforts are ongoing, but Russia and the US have a considerable divide to overcome.
Russia wants Nato to cease its expansion efforts and remove American nuclear weapons from Europe, says Patricia Ribeiro (pictured), portfolio manager, emerging markets equity, American Century Investments.
“The US and its Nato allies have firmly opposed Russia’s demand,” she adds. “However, each has committed to finding a diplomatic solution.”
If an accord cannot be reached, the US is considering sanctions with financial implications. According to Ribeiro, the ones to keep an eye on are:
- – Sanctions against senior government officials and Russian banks
- – Investigations of president Vladimir Putin’s wealth
- – Ban on US investment in all newly issued Russian sovereign debt
- – Sectoral sanctions on Russian extractive industries
The most severe, she says, would be disconnecting Russia from the Society for Worldwide Interbank Financial Telecommunications (Swift).
The secure communications platform connects thousands of financial institutions: allowing banks, brokerages and other institutions to send and receive information – such as transferring money to an overseas account or settling a securities trade.
Rebeiro says this has been characterised as the “nuclear option” as it would likely cause significant economic disruption to Russia.
Oil and inflation conflagration
“It is impossible to know, at the moment, whether it is Russia, or the West, that bears the greater responsibility for creating the tensions,” says Hawksmoor’s CIO private clients & head of research Jim Wood-Smith.
Both sides, arguably, have benefited, he says. “Putin has successfully flexed his muscles. He may also have succeeded in re-uniting Nato.”
Wood-Smith adds: “Whilst clearly good news for companies that manufacture missiles, there are wider implications. The first is the supply of energy.
“According to the US Energy Information Administration, Russia is the world’s third largest supplier of oil and the second largest source of dry natural gas. Given our knowledge of the world’s half-hearted crawl towards carbon net zero, this makes Russia exceedingly important.
“It becomes doubly exceedingly important when the West is staring at both barrels of generationally high inflation and rising interest rates. The crawl towards reduced dependency on Russian fossil fuels needs a sharp kick up the backside.
“Inflation calculations need a lower oil price; having reports today that petrol pump prices have set new record highs in the UK is not what anyone needs to see.”
Sharp drop in Russian equities despite high gas prices
Much of the focus has been on Europe and Ukraine, but that does not mean that Russia has escaped unscathed.
Liontrust Russia Fund manager Thomas Smith says: “Russian equities fell by a third from their October high to the January low, erasing all of last year’s gains. This is despite the oil price surging to $95/bbl and, combined with a weaker currency, reaching record highs of over RUB7,000.”
This compares with an average of RUB3,700/bbl over the past 10 years, he adds.
The stock market weakness “is due to the rising geopolitical tensions” and “the sell-off reflects the market pricing in the likelihood of new financial sanctions against Russia”.
While the country has made “huge strides” to improve its macroeconomic resiliency in recent years, financial sanctions could still be very damaging, Smith says.
“While a military invasion of Ukraine, and therefore radical new sanctions, cannot be completely ruled out, it appears unlikely because of the political and economic costs involved.”
Smith adds: “Given the strength in earnings of Russian companies benefitting from high commodity prices, combined with the recent weakness in prices, Russian equities are now trading at less than six times forward earnings and more than 50% discount to broader emerging markets.
“There is clearly a significant geopolitical risk premium embedded in valuations. There would no doubt be further downside if the conflict in Ukraine saw material escalation, but as both sides are incentivised to avoid escalation and are now talking more frequently, there is potential for de-escalation in the months ahead.”
Russia ‘decoupling’ could send European natural gas prices soaring
Capital Economics senior global economist, Simon MacAdam, believes “over the longer term, whether Russia ends up invading or not, this geopolitical flare-up is likely to speed up the process of Russia’s decoupling from the West”.
Against the current inflationary backdrops, he says “a Russian invasion of Ukraine or a severe ratcheting up of sanctions would add as much as two percentage points to inflation in developed markets, particularly in Europe”.
His comments were made before leaders from across Europe descended on the two nations in a bid to lower the temperature, and more than a dozen countries recommended their citizens leave Ukraine.
“The EU is heavily reliant on imports of Russian energy,” MacAdam adds. It supplies 40% of the bloc’s oil products and coal, and a fifth of its natural gas.
“Given that there is no alternative producer with the capacity to fully offset lower gas supplies from Russia, European natural gas prices could plausibly return to their peak of €180/MWh, which would boost eurozone inflation by 1.5 percentage points.”
Wholesale food prices could also be set to shoot up further. Russia and Ukraine collectively export a quarter of the world’s wheat. Ukraine is also a major exporter of corn, whereas Russia is the world’s biggest exporter of fertilisers.
Developed markets would usually ‘look through’ these jumps in inflation, says MacAdam. But, having already been buffeted by a number of shocks, these events could force policymakers to tighten policy more than they otherwise would.
Where to go from here?
Russian playwright Anton Chekov once said: “If, in the first act, you have hung a pistol on the wall, then in the following one it should be fired.”
With Russian troops engaging in military exercises along its border with Ukraine, many will be hoping that Chekov’s words don’t prove prescient.
Until a move is made – whether that sees a military advance into Ukraine or retreat from the border – it will be a waiting game to see how renewed tensions between East and West play out.
Polling by the European Council of Foreign Relations shows that the majority of those surveyed across seven EU member states believe Russia will invade – especially those in Poland (73%).
The only exception was Finland, where 44% of respondents think it will happen.
American Century Investments’ Ribeiro believes “the likelihood of Nato or US troops confronting Russians soldiers remains low”.
“We are not currently making changes to our positions,” but adds the team is monitoring the “fluid” situation.
