THE WAR IN UKRAINE:

CONSEQUENSCES AND CONSIDERATIONS FOR THE FINANCIAL MARKET

9.3.2022 /  Articles

 

I was going to write an article about central bank policy in light of the high inflation, its impact on the economy and what to expect for the future, but then something happened what we hoped would be entirely avoided: Russia invaded Ukraine, causing a humanitarian disaster and sending the markets into turmoil. As a result this article will address the war from economic and investment perspective. Sadly it's unavoidable to write about it because it is currently driving the global news and markets and it needs to be addressed. But let's start with the a recap of the current situation itself.

 

Every war has some impact on the markets but in this case it is particularly significant for a multitude of reasons, one of the most important ones being that it involves the world's largest exporter of natural gas, which also happens to have nuclear weapons at their disposal and they are apparently not afraid to use them should other countries become directly involved in the conflict in support of Ukraine. What also doesn't help is that the Russian forces reportedly have captured multiple nuclear powerplants in Ukraine, including Chernobyl (the site of the 1986 nuclear disaster) and Zaporizhzhia (Europe's largest nuclear plant), which temporarily caught fire due to shelling, raising concern for the safety of entire Europe.

 

The concern is taken seriously and as a result other nations have so far only resorted to indirectly supporting Ukraine by implementing hard-hitting sanctions on Russia and providing military and other supplies as well as humanitarian aid to Ukraine and the refugees which reportedly at this time already count well over one million 10 days into the conflict. Meanwhile Ukraine has also submitted its candidacy to join the EU. While the EU is an economic and not a military union, and the procedure to join takes many years, it's a clear sign of Ukraine's willingness to join the west, distancing itself from Russia.

 

I'm not an expert on war and there are many conflicting stories in the media as each side is trying to push its own narrative to its advantage. On one hand Russia claims that the increasing proximity of NATO forms a direct threat to its security and justified their invasion of Ukraine as a way to liberate (»de-nazify« as they called it) the country. The other side claims that NATO was never a threat to Russia, that Ukraine is a peaceful democracy and that President Putin aims to restore the former Soviet empire, even resorting to war crimes for which the International Criminal Court in the Hague recently initiated an investigation.

 

What I know is that pretty much everybody saw this war coming and we were just hoping it would never materialize. This conflict has a long history of being in the making, there are arguments on both sides but neither side will provide the complete truthful story. One factor however that is rarely mentioned is Ukraine's mining and agricultural resources. Ukraine has some of the largest reserves of uranium, titanium, iron ore, mangan, gallium, and other minerals in Europe and the world. According to the Ukraine government agency UkraineInvest, 117 out of 120 known minerals are found in Ukraine with total mining output accounting for 15,3 Billion dollars. In addition Ukraine provides 33% of the world’s black soil and is a lead producer and exporter of cereal grains with  approximately 50 million tons of exports annually. It is not called the »bread basket of Europe« for no reason. My point is, while both sides provide their own arguments, very little is said about the actual wealth of Ukraine's soil. War is usually about money and power, sadly not so much about the well-being of the people, and when looking for true answers, it is always recommended to follow the money trail.

 

With all that said, let's now have a look at the impact on the markets. War, and particularly a war involving a nuclear power in the heart of Europe obviously sends the global markets into a frenzy. Every day brings new developments and nobody knows how or when it will end. This uncertainty causes shares, currencies, bond yields, commodities and so forth to make strong movements. The most common measure of volatility is the VIX index – the higher the VIX index, the more the markets are volatile, and this can be either as a result of a significant positive or negative event. Currently the VIX index is above 35 and climbing. Last time the markets had such volatility as it does now was in November 2020 when a COVID vaccine was announced. And prior to that it was in March 2020 when COVID was declared a global pandemic.

 

When uncertainty rules the markets, investors typically flee for safe havens, the most known ones being US dollars and precious metals, primarily gold. Since the invasion started on Thursday 24th of February. The dollar gained from 1,1309 to currently (Monday 7. march) 1,0816 Dollars per Euro or nearly 5%. Gold gained from 1910 to currently 2004 dollars per ounce. Note that because gold is valued in US dollars, they typically have negative correlation: when the dollar gains, gold drops, and vice versa. Under the current circumstances they both gain simultaneously as demand for both of them increased. The dollar is currently at its strongest level since May 2020 (before the Federal Reserve announced the financial stimulus to combat the economic pain from the COVID lockdowns) and gold is at its strongest level since August 2020.

 

With Europe importing almost half of its gas and a quarter of its oil from Russia, prices of both skyrocketed on the fear that Russia could retaliate by restricting supplies to Europe. Germany however signalled on the first day of the conflict they won't allow being strong-armed on gas supply issues by suspending the approval for the Nord Stream 2 gas pipeline, effectively shutting it down itself as one of the first sanctions. Consequently the gas price jumped from 4,623 to currently 5,146 MMBTU. The biggest gainer however is oil with Brent crude climbing from $96,84 to currently $125,33 per barrel after shortly exceeding $130 per barrel, the highest price since 2008. The biggest jump occured as the U.S. and its Western allies discussed the banning of Russia crude imports to further penalize the invasion of Ukraine.

As you are well aware, prices of both natural gas and oil, as well as pretty much every other commodity and product, already have been climbing tremendously over the past year as the global economy recovered from the COVID lockdowns with surging demand unable to be fulfilled as supply chain issues caused shortages. As a result the USA had an inflation of 7,5% in January, measured year over year. Core inflation, which excludes food and energy prices, stood at 6,0% in January. Both are at the highest level since 1982. In the Eurozone inflation in January climbed to 5,8%, an all-time high.

 

As mentioned earlier, I originally planned to write a detailed article about the inflation and monetary policy. The essence of it, since it matters to the current developments, was as follows. Inflation is currently spiking but it cannot sustain such high levels. Essentially since November last year markets have been correcting themselves as central banks virtually stopped printing fresh money and in anticipation of central banks raising their interest rates in order to further combat this inflation. In addition the strong demand from last year is beginning to wear off while the supply chains are mostly restored. As a result my expectation was that this inflation would decrease rapidly starting around April this year. With inflation decreasing, central banks would not need to increase their interest rates as dramatically as is anticipated. And that is the key reason for market optimism in the second half of this year.

 

Despite the invasion and the further climbing gas and oil prices caused by it, those original expectations are still applicable now, even under the current circumstances, though it may cause a delay in inflation settling down. How long that delay will be depends on what happens in Ukraine. ECB Chief Economist Philip Lane said that the central bank is closely monitoring the economic consequences of the war in Ukraine and will do whatever is necessary to support the Eurozone's rebound.

 

In Russia the macro-economic and financial situation is of course very bleak. The Russian MOEX index lost roughly half of its value in a matter of days, dropping from 3400 to as low as 1680 rubles after which it partially recovered, but the Moscow exchange has now been closed since february 25. A further sell-off is likely the moment the exchange reopens. Also the Russian Ruble is collapsing, dropping from 81 to currently 128 rubles per dollar after going as low as 154 rubles per dollar and could get much lower day by day as the conflict drags on. This in part as a result of the sanctions, including certain Russian banks being excluded from SWIFT and restrictions on the Russian Central Bank, essentially locking out Russia from executing the majority of foreign transactions. As a result the Russian Central Bank increased their interest rate from 9,5% to 20% as inflation is spinning out of control.

 

So what is our current investment strategy at Primorski skladi? Luckily we have almost no exposure to the Russian or Ukrainian market. With the Russian army building up along the Ukraine border during the weeks prior to the invasion, it only seemed prudent to avoid such investments. Already before the invasion occured we had also replaced most of our growth stocks with value stocks because value stocks are generally less sensitive to the central banks' anticipated interest rate increases. We also already had a fairly large weight in gold mining companies, commodities and energy stocks and are sustaining a slightly larger than usual cash position. These positions counter losses on other positions in portfolio. As a result our asset allocation so far proved resilient as our funds are handily beating the overall market and losses are limited.

 

We intend to hold our current portfolio as it is but of course closely follow the developments in Ukraine. For the sake of the people, I hope this soon comes to an end. I think we all do.

Rudy Marchant
Fund manager Primorski skladi d.o.o. Koper