Original Content: AXA IM

But beyond the initial market volatility, there are potential implications for global energy supplies, the path of inflation, and monetary policy. And then, there are the sanctions on Russia to consider and the broader economic disruption these could create.

Below, five AXA IM experts outline their thoughts on the crisis in Eastern Europe.

AXA Group Chief Economist, and AXA IM Head of Research, Gilles Moëc

The international community has stepped up to restrict the Russian central bank’s access to its reserve assets. While some assets are outside the reach of Western powers, more than half are held in NATO countries - and as such, they can’t be used by Russia to shore up its currency, and we have witnessed a massive depreciation of the rouble. Inflation in Russia was already high, and we can expect it to accelerate, further eroding purchasing power and likely triggering a recession in Russia. Russian banks also have to endure restricted access to the international payments system SWIFT. This has created a sense of panic over its ability to shift money in and out of the country. We have seen queues at ATMs, and this is very likely to turn into a full-on bank run. Russia’s central bank can, of course continue to print money, but this will only exacerbate the problem by fuelling additional inflationary pressure.

Crucially, however, the international community has allowed Russia some wriggle room by not completely cutting it off from SWIFT, as it wants Russia to be incentivised to sell oil and gas to the rest of the world, and especially Europe because it will be in dire need of hard currency.

Russia is not a big economy nor a major player in international trade. What is more significant are oil and gas imports, given Europe’s dependence. We have already seen very significant increases in wholesale gas prices, which is hitting Europe’s purchasing power. Electricity is also a very important channel as natural gas is the major energy source for electricity generation; this backdrop has impacted already fragile countries like Spain and Italy. 

If the crisis continues and oil hits US$125 a barrel and gas €125 per megawatt-hour, the impact on Eurozone GDP growth could be quite significant, perhaps one percentage point of GDP growth this year and next. Notably, this would be a significant growth shock to Europe, but not to the rest of the world, where the impact would be far less severe.

The European Central Bank (ECB) is likely to be much more prudent than it was before the crisis and we do not expect an interest rate hike until December at least; equally, we anticipate the ECB will continue with quantitative easing for a while longer. Overall Europe needs to rethink its energy mix as its dependence on Russian oil and gas is a geopolitical headache. The crisis is also likely to trigger a catch-up in military spending, adding to the pressure on public finances throughout Europe.

Global Head of Multi-Asset Investments, Serge Pizem

This crisis is a wake-up call for Europe. And Europe has woken up in a big way; geopolitically this is a huge inflection point for the region. I expect to see more spending on defence, as well as cybersecurity - and a greater NATO presence in Europe – and less dependence on Russian gas. This will all have a huge consequence for the future.

In the late 1960s, Russia accounted for around 20% of world GDP, but that is now less than 2%. Russia is rich in commodities (oil and gas first), a small economic player, but an aggressive military player. Trying to understand what President Vladimir Putin wants is a difficult question to answer, but later on there could potentially be an ‘Arab Spring’ moment in Russia, as the population does not seem to be supporting Putin on the Ukraine invasion.

If we look at the military events of the past 50 years – and while past performance should never be seen as a guide to future returns – what we can see is that it was better not to trade on those days when crises broke out. The Iraq invasion of Kuwait in 1990 was one of the worst but the market had rebounded within four months; after 11 September 2001, it took the market three weeks to recoup its losses.1

This crisis has occurred, just as the global economy has once again started to accelerate post-COVID-19. The economy is however constrained by some bottlenecks, but this situation is improving – and if this crisis reduces demand, it will potentially help ease inflation. Fundamentally we believe the economic rebound and easing supply-side issues bode well for company earnings growth.

From a market perspective, we believe the gap between nominal bond yields and inflation expectations should close in from both sides; this is why we have maintained a moderately constructive view on equities – even though we have questions about Putin’s motivation and how we get out of this crisis. We are more cautious on investment-grade credit as valuations are no longer attractive due to tight spreads. In terms of commodities and sovereign bonds, we are neutral. Regarding the former, while rising geopolitical tensions support commodity markets, supply constraints should gradually ease. This crisis will accelerate inflationary trends through energy prices, especially in Europe, where dependence on Russian gas is the highest.

Ultimately, presently I believe it is vital to keep calm and look through the crisis, as past military events tell us it is potentially wiser to keep our longer-term investment convictions.

Head of Emerging Markets and Asian Fixed Income, Magda Branet

Investors have experienced some eventful days in the emerging market debt universe. However, the current crisis needs to be put into perspective as Russian and Ukrainian debt represents a small portion of global fixed income. Until Russia invaded Ukraine, it had one of the strongest balance sheets in emerging markets. As such, there were no issues around its ability to service debt, but clearly, there are now questions on its willingness to pay.

On 28 February, Russia’s central bank instructed brokers to not execute sell orders from foreign investors – that was mainly focused on local currency-denominated instruments but it did lead to a reaction from international financial institutions who started withdrawing from quoting and settling Russian debt in both local and hard currency. Right now, investors are in limbo. We think that even with restrictions, Russia should still be able to honour its sovereign obligations, but it may choose not to in retaliation to sanctions.

As far as corporates are concerned, here we have certain worries around SWIFT and whether companies will be able to process payments. If we get to the point where there is a complete suspension of payments, this could push the entire Russian corporate sector into default. But the corporate sector has a very high willingness and ability to pay as it holds assets abroad and can get around these restrictions (only a few banks have been cut off from SWIFT). They would also want to honour obligations in order to maintain access to US dollar financing. Should corporates be cut off from external financing,  it should increase the oligarchs’ pressure on Putin, as they have already been hit by sanctions in their personal wealth and do not want to see their businesses go bankrupt too; this could backfire against the regime.

In Ukraine, the government is very willing to pay its debt, it has ample financial support from the West and even a restructuring of debt would be mild, if the current government stayed in power. If the conflict ends with a new Russia-imposed government, the situation will be different, and we would be facing a harsher default event. More broadly, contagion risk to emerging markets has been moderate so far. There are some ‘winners’ among commodity exporters - for example, oil exporters in Latin America and the Middle East. Asia is more insulated, but inflation could be a channel of contagion; however hopefully if it is, it should be moderate.

Global Head of AXA IM Equity, Mark Hargraves

In the short term, there are significant uncertainties and equity markets will remain sensitive to the news flow, especially in Europe, while the US and Asia are less impacted by what is happening in Ukraine. But overall, markets have remained, so far at least, relatively resilient; we had a sell-off in late February, but we have since seen a modest recovery.2 And while equity valuations are not cheap, they are more attractive, as they have pulled back over the past six months from very elevated levels as there has been a major rotation from growth into value.

The current economic and associated earnings impact for major economies appears to be considered manageable by investors. The risks lie in more significant disruption to energy supplies and the associated knock-on effect on economic activity.

Over the coming months, equity markets will likely see earnings downgrades, and following the initial COVID-19 earnings recovery we are moving towards a more mid-cycle equity market backdrop. Markets have been led by financials, energy, and commodity stocks over the last 18 months but now financials are facing short-term risks while energy and commodities are likely reaching the peak of the current earning cycle. 

With earnings growth moderating from 30% to 40% growth in 2021 we anticipate this to slow to single-digit growth in 2022, with risks on the downside supporting a rotation towards more defensive and secular growth companies.3 This is supported by the fact that concerns over monetary policy tightening – in particular by the Federal Reserve - have contributed to a major derating of secular growth companies resulting in an improved relative valuation profile.

As such, provided there is no major escalation in the conflict, which significantly impacts the earnings outlook, this - combined with a more muted interest rate cycle - is supportive for equities in 2022, with market leadership shifting to higher quality and more structural growth companies.

Longer term, a major focus in Europe on energy security will likely manifest itself in both developments of the liquefied natural gas capacity to reduce dependence on Russian gas and an acceleration of the shift to lower carbon solutions, with a particular emphasis on accelerating the economics of energy storage. 

Equity returns are a function of the earnings they deliver and generally, historically conflicts haven’t caused material changes in the earnings regime; broader macro-economic topics are much more likely to have an impact in the longer term. Currently, we believe the structural forces of demographics and technological innovation will likely continue to have the greatest impact on medium-term equity returns.

Chief Investment Officer, Core Investments, Chris Iggo

We are living in a very uncertain world right now because of the military conflict in Ukraine. It’s difficult to see how the situation will progress, how it will end - and what the outcome will ultimately be. This makes the 2022 economic and market outlook far from clear.

But while this lack of transparency makes life difficult for investors, it’s vital to avoid panic and see how things unfold. The decisions taken - and sanctions imposed - by the international community will disrupt payments and trade with Russian entities and severely impact how Russia services its debt.

There is of course the potential for unknown consequences stemming from this disruption, including financial flows and supply chains.

What we do know is that energy prices are even higher than before, that inflation will increase further, and this will be negative for economic growth, especially in Europe. This deterioration in the growth and inflation outlook does demand some higher risk premiums in equity and credit markets, and we have seen this already.

However, we will likely hear a less hawkish tone from major central banks – the market is already anticipating less interest rate rises than previously priced in - with perhaps the exception of the Federal Reserve, which we still believe will hike later this month.

In bond markets, we have seen yields come down and markets are suggesting there will be no aggressive, sustained increase in bond yields over the coming years. Lower real yields are positive for equities – we have seen over the past six months that rising real yields have been aligned to the rotation from ‘growth’ into ‘value’ shares. A reversal of that, meaning lower real yields, could provide further support for a move back into growth stocks.

Europe will likely take the brunt of the hit in terms of growth and earnings. If earnings don’t come down too much, then equity markets are already close to more attractive valuations.

What we really want to see though is a cessation of the hostilities, some easing of the pressures in energy markets, and a clear political map forward. We are certainly not there yet – so uncertainty will be the key driver for now.

Sources

[1] Goldman Sachs/AXA IM

[2] As of 28 February

[3] AXA IM 2022

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