The current situation is unclear, both in terms of Putin’s immediate decisions and his ultimate objectives, but what is apparent at the time of writing is that Russian expectations have been surprised both by the level of resistance offered by the Ukrainians on the ground and by the strength of the response from the international community, including measures such as significant economic sanctions and the provision of military equipment to support the Ukrainian defence.
This has led Putin to respond erratically, increasing the level of uncertainty around the crisis, and while the relative strength of the Russian forces suggest that he is likely to capture a significant city such as Kyiv or Kharkiv, it would be difficult for Russia to maintain a permanent hold over the whole of Ukraine.
In this scenario, our expectation would be that Putin attempts to use future success as a starting point for negotiation where he may aspire to break Ukraine into smaller units and / or remove the pro-Western government, allowing Putin to claim domestically that he has achieved his objectives.
Time is not on Putin’s side, however, as the longer that the crisis continues, the more support that can be provided by the West to the Ukrainian government, while within Russia the economic sanctions will start to bite, weighing on Putin’s domestic support. This could increase the chance that Putin raises the stakes further by deploying unconventional military methods and increasing market uncertainty.
Market reaction and outlook
The effect on Russian assets specifically was severe, with declines of around 70% on Russian stocks, the Russian Ruble weakening significantly after Russian banks were excluded from the international settlement system known as SWIFT, and an increase in Russian interest rates to 20%. Russia has spent several years building foreign currency reserves of $600bn to improve resiliency, though is now unable to access at least half of that following the imposition of sanctions. While previous sanctions and the increased currency reserves have reduced the links between western companies and Russia, there are likely to be defaults by Russian and Ukrainian importers. With Russia being a significant supplier of oil and gas to Europe, and Ukraine being a major source of agricultural products, supply shortages and commodity prices are likely to be the main transmission mechanism to markets and the broader economy. For the moment gas continues to flow to Europe.
More broadly, however, global equity markets have stabilised in recent days after an initially negative reaction, while G10 government bond markets have rallied somewhat as investors have softened expectations for the pace of monetary tightening by major central banks.
While markets will remain volatile in the short term, over the next year we continue to see a resilient global economy with economic growth supportive of risk assets and we maintain our expectations of higher rates as central banks respond to rising inflation There will be a hit to consumer incomes and corporate earnings, but the knock-on effects are dampened by strong balance sheets in both sides and a backdrop of strong economic momentum going into the crisis, as Europe & the US bounce back from omicron-induced weakness. We also see scope for further expansion of fiscal policy in developed countries to soften the effect on consumers, as well as specific areas of increasing importance such as infrastructure and defence.
Taking a longer view, it seems likely that the Ukraine crisis results in an outcome diametrically opposed to that intended by Putin, with Western governments uniting in response to the Russian threat, a possible expansion of NATO to include Sweden and Finland, and an increase in military spending, including from Germany. China may benefit from better access to Russian commodities as they are diverted from European markets, but other countries in Asia may need to consider an uncomfortable choice between growing economic ties with China and a reliance on Western governments to counter growing Chinese territorial ambitions. All in all, it feels like another step away from unfettered globalisation and a return to an era of frostier relations between the West (and affiliated countries such as Japan) and an emerging ‘alliance of autocracies’ led by China, with fault lines across Eastern Europe and Asia.
Exposure and Activity
The Universal and Sustainable Universal fund ranges have no direct exposure to Russian, Ukrainian or Polish assets, so the effects of the crisis on investor portfolios is limited to volatility in global equity and bond markets. We remain underweight fixed income reflecting concerns around inflation and higher yields.
While we maintain a modest pro-risk stance in equities, we had reduced this in mid-February with a view to increasing the exposure over coming weeks or months on possible market weakness. With the Ukrainian crisis flaring up more severely than anticipated, and a United States interest rate hiking cycle likely to get under way in March, we expect market volatility to continue but believe that by the end of the year most equity markets will have risen above current levels.
The situation remains fast-moving and fluid. We will continue to monitor the situation in Ukraine and in markets and, where opportunities arise, look to add exposure in assets that we favour.