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A Cold War in the Global Markets


COVID dominated headlines in 2020. Vaccines (and later inflation) dominated headlines in 2021. The conflict between Russia and Ukraine has dominated headlines for much of 2022, and in this article we deep-dive into the impact that these developments have had on markets around the world.

Setting the Scene

From October 2021 and possibly earlier, Russia began shifting troops to its border with Ukraine unbeknownst to many.

It was only in early 2022 that officials worldwide took note of the threat it posed to Ukraine and ever since there were attempts at diplomatic resolutions, with very little success.

This has now turned into an all-out war between Russia and Ukraine with some involvement by Belarus (in alliance with Russia) along its mutual border with Ukraine.

Early Moves

From a financial perspective, the greatest losers will certainly be Russia and Ukraine. Ukraine from the direct economic damage and exposure to combat, and Russia largely from sanctions.

In the first day of fighting alone, the Russian stock market fell by about 50% which is one of the sharpest drops in modern financial records.

The West has responded to Russia’s invasion by imposing various sanctions, some of which have been imposed by Boris Johnson on major Russian banks and three wealthy Russian individuals.

Russian banks and stock market activity are expected to be hit hard and, as a result of the rouble collapsing, there have been numerous bank runs across Russia.

Sign displaying foreign currency exchange rates to the Russian rouble at an exchange bureau in Moscow
Source: Bloomberg

There are also talks of controls on US technology being exported to Russia and the potential for sovereign debt restrictions on Russia’s secondary investment market (in addition to already existent primary market sanctions).

Among other sanctions and restrictions, flying to and from Russia have been banned by several countries.

Observing the Russian Market

Investment analysts at Morgan Stanley broke down the current situation into four possible outcomes in early February before the conflict began:

  1. Deescalation (with a 50% upside for markets) – this would constitute an official withdrawal of troops announced by the Russian state
  2. Limbo
  3. Partial escalation – this is defined by recent market lows upon the release of news relating to military advances
  4. Material escalation (with a forecast 30% downside and the scenario currently being played out) – if a full military invasion was to begin

The downside forecast was not too far off what we have witnessed with some markets over- and underperforming relative to downside expectations.

In addition to comparisons to the Crimean crisis in 2014, there are many useful indicators of how the market has responded thus far and may continue to do so.

Two of these are the cost of equity in Russia (19% as of 20th February 2022, likely to be higher now, which is below that observed in 2014) and the dividend yield (16% at current commodity prices as of 20th February 2022, likely to have risen since).

The current dividend yield is staggering and well above its value in recent years, largely due to changes in the nature of Russian corporate governance and payout policies.

It has also been noted that the Russian market was responding a step ahead of global markets to the earlier tensions which may create opportunities for agile investors to spot opportunities to generate alpha (returns in excess of the market), a feature also amplified by growing risk premiums.

The Wider Global Markets

Russia is a key global exporter of global commodities beyond the oil and European gas that it is widely known for; it exports 37% of global palladium which is critical in the auto industry for manufacturing.

It also supplies a substantial amount of nickel and aluminium, reaffirming its position as a key player in global industrial supply chains.

Palladium exported from Russia
Source: Reuters

Thus the shocks of this rapidly deepening crisis is being felt in not only the Russian market but also the wider global markets, in particular the European markets.

European equities are down disproportionately compared to wider global equities, but experts believe that there is a low probability of negative spillovers to the fundamentals of European firms.

Initially, this decline was believed to be more short-term and sentiment driven but, with oil prices above $110/barrel and commodity prices skyrocketing, there is potential for significant long-term disruption and inflation persisting well into the year independent of any COVID factors.

The NASDAQ index has also taken multiple hits in the past few weeks, firstly from the expected rate rises announced by the Fed (which you can read about in our February 2022 market review) and now from the potential conflict.

US stocks have, however, rallied upwards and largely benefitted from the downturn in the European indices as investors place more faith in the US economy.

Looking Beyond Today and Tomorrow

The geopolitical risk of further conflict between Russia and the west is unlikely to subside even beyond this particular episode and, over the past few years, has been priced into Russian financial instruments.

Risk premiums have fluctuated in line with various political and socioeconomic developments relating to Russia and these have been accompanied by major securities purchases and sell-offs in the Russian markets.

What many may find surprising is that Russian equities have in fact outperformed emerging markets since 2014 by about 13% per year.

This is even greater at 15% when dividend payouts are included, in line with changes in Russian corporate governance referenced to earlier, so perhaps investment opportunities in the Russian market should not be overlooked when focusing purely on financial returns and remaining neutral (trading of Russian financial instruments may not be feasible due to capital controls in certain countries and appropriateness would depend on the investor’s beliefs).

Given this tension between Russia and the West, combined with the upward repricing of interest rates, value stocks are being more strongly recommended than growth/cyclical stocks across many markets (though this should be reviewed on a case-by-case basis).

Regardless of investment opportunities that may present themselves via ongoing developments, it is clear that the chill from this cold war really is preventing the global markets from a COVID thaw.

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