The grim reality of war returned to Europe this week, something that most of us thought was consigned to history, as after several weeks of uncertainty, Russia invaded Ukraine. Several countries including the US, the European Union, the United Kingdom, and Japan have imposed sanctions on Russia in response. However, tellingly, so far, they have stopped short of including companies involved in the export of oil and gas to the European Union and neither has Russia been excluded from SWIFT, the cross-border exchange system. This is despite the European Parliament adopting a resolution on the 29th April 2021 to exclude Russia in the event of an invasion of Ukraine. There was also a deafening silence from China on the matter.
Markets have been volatile in response, with government bonds not providing the haven status normally associated with them as the sharp move up in energy prices has exacerbated inflationary concerns. However, it has not been one-way traffic of selling pressure as markets are dispassionate to war and focus on the economic impact. A combination of sanctions that are deemed ineffective, at least in the short term, combined with the possibility that this event may temper central banks’ interest rate hiking plans, has led to a strong market rally at the end of the week.
As of 12pm on Friday, London time, US equities over the week have fallen 1.4%, whilst technology stocks dropped 0.6%. European stocks lost 2.3% and UK stocks fell 1.6%. The Japanese and Australian markets dropped 2.5% and 3.1% respectively, whilst the emerging markets dropped 6.2% with a wide dispersion of returns amongst country returns. Asia Pacific markets fell 5.2%, whilst Latin American stocks were down 2.0%, reflecting concerns over Chinese intentions towards Taiwan.
Haven US Treasuries, having initially rallied on the news of invasion, have subsequently sold off as markets have increasingly focused on the inflationary impact of the conflict with respect to energy prices. The 10-year yield on US Treasuries, which moves inversely to price, is now trading at 2.00% having started the week at 1.93%. It was a similar story for German bunds and UK gilts, both yielding higher levels at the end of the week, at 0.23% and 1.47% respectively.
Gold briefly provided a hedge intraweek, as the precious metal rallied by 4%, but it is now trading back down at levels close to where it began the week at $1,898 an ounce.
However, industrial commodities have been squeezed higher and have hung onto much of those gains whilst so much uncertainty continues to exist. Brent crude oil peaked at $105.6 on Thursday, and is now trading at $99.2 a barrel, an increase of 6.0% over the week, whilst US WTI (West Texas Intermediate) has given up more of its gains, having touched just over $100 a barrel on Thursday, it is now trading at $93.4, an increase of 2.5% for the week. Iron ore is up 2.7%, whilst copper bucked the trend and is trading down 0.7% at $9,918.
US and UK intelligence had been forecasting an invasion for several weeks now, even if this was not universally anticipated by politicians. In addition, NATO has for some time made it clear that any conflict in Ukraine was not its war. As horrendous as this conflict is on a sovereign country by Russia, provided the conflict does not spill outside of Ukraine, markets are unlikely to care about the conflict itself too much. Although that is not to say that the volatility we have seen this week has passed. However, what markets will focus on are the likely knock-on impacts from this war.
So far, the sanctions imposed on Russia are unlikely to trouble Putin too much. He has after all been planning this for many years. Russia has one of the lowest debt to GDP ratios in the world, standing at about 20%, therefore their reliance on foreign investors to fund themselves is somewhat limited. And in all likelihood, they can turn to China for help if needs be.
For Russia, what is much more significant is the price of oil and gas and their ability to export it. Given that this conflict has dramatically pushed prices up, and the European Union is dependent on Russia for about 40% of its gas imports and 30% of oil, this conflict is only filling up Putin’s coffers quicker.
What is critical at this juncture is how the West continues to respond to Russia, and in turn, how Russia responds back. If the West is unwilling to tighten sanctions further, in large part because in the immediate term the blowback from any further sanctions will hurt the European Union more than Russia, then financial markets’ concern over the conflict is likely to ebb.
However, if Russia chooses to restrict oil and gas supply in retaliation for any sanctions imposed thus far or in the future, this could lead to further energy price rises and the prospect of stagflation which would be very negative for markets.
How has Europe allowed itself to become so dependent on Russia for something as important as energy. And ultimately, longer-term, if Europe does not stand up to Putin, what does this mean for the Baltic states?
Historically, as long as conflicts have remained contained, market losses have swiftly recovered. And in all likelihood, central banks will temper their interest rate ambitions in the face of this conflict. But this is a fast-moving situation, and we are evaluating the situation as time goes on.
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