The Ukraine conflict has led to a humanitarian crisis on a scale not seen in Europe for decades. For investors, though, history suggests geopolitical conflicts usually do not have a lasting impact on risk assets. Hence, investors are better off with a diversified allocation that reflects their risk tolerance and hedge against near-term risks. Seeking refuge in cash is likely to hurt long-term returns, especially given inflation today, as investors are likely to miss the upturn when it comes.
The financial implications of the Ukraine crisis can be assessed, in terms of three red lines: 1) The severity of Western economic and financial sanctions following Russia’s invasion; 2) the extent of disruption to oil and gas flows from Russia; and 3) whether conflict spills beyond Ukraine’s borders. Over the past week, the first of the three red lines has been crossed after the US and Europe imposed wide-ranging sanctions against Russia, including taking extremely rare measures to remove major Russian banks from the SWIFT payment messaging system and freezing the reserves of Russia’s central bank. These steps have led to a sharp decline in the RUB and Russian assets. However, Russian assets have only marginal weights in global equity and bond indices. Thus, the global impact of the SWIFT step is likely to be manageable.
Russia’s impact on oil and gas markets, metals (palladium, nickel, copper, platinum) and agricultural crops (wheat) – marking the second red line – is greater. There are reports that oil and gas flows from Russia, while not directly sanctioned, are slowing as importers struggle to finance the transactions. This explains the 16% jump in oil prices in the past week. However, Russian oil flows to Asia is continuing for now, with countries taking advantage of discounted prices to boost inventory. Gas flows to Europe were slowing even before the latest escalation.
Meanwhile, there is a low probability that the third red line will be crossed soon, given Russia’s singular focus on Ukraine and that it would imply a much bigger Russia-NATO conflict.
The above framework leaves with two main scenarios. In base case, Russian oil and gas continue to flow to Asia and Europe. Also, major OPEC producers, such as Saudi Arabia and the United Arab Emirates (and potentially Iran), and developed countries are likely to replenish any lost supplies by lifting output and releasing more stockpiles. In this case, oil prices are likely to fall back below USD100/bbl over the next 6-12 months and the broader impact on global markets is likely to be limited. Under this scenario, risk assets are likely to rebound as the market refocuses on the gradual global economic recovery, including in China (where policy continues to ease), and robust fundamentals in the US, as seen from the latest PMI and private payrolls data. Europe, meanwhile, is likely to benefit from a significant increase in fiscal spending on defence and energy infrastructure as a direct fallout of the Russian crisis.
Risk assets will likely be further supported by major central banks dialling back their hawkishness – markets are pricing over five Fed rate hikes this year, including a 25bps hike in March, versus up to seven earlier. Fed Chair Powell told the US Congress he remains focussed on tackling inflation, but recognises the rising uncertainty posed by Ukraine’s crisis. The global outlook could, of course, brighten further if Russia and Ukraine reach a truce. The following pages lay out our preferred assets that would benefit from a revival of risk appetite.
The alternative scenario, where oil and gas flows from Russia are severely curtailed and OPEC and/or OECD countries are unable to replenish the lost supplies, would raise the risk of stagflation (characterised by stagnating output and rising inflation), especially in Europe. History suggests gold is the best hedge against stagflation; energy-related assets are also likely to benefit, since oil and gas prices would be a primary driver.
Finally, Chinese government bonds (CGB) could also be a key beneficiary given they have emerged as one of the most ‘anti-fragile’ assets through the past decade’s geopolitical conflicts.
This article is for general information only and is subject to the relevant disclaimers available at https:// www. sc. com/en/regulatory-disclosures/#market-commentary-disclaimer. It is not and does not constitute research material, independent research, an offer, recommendation or solicitation to enter into any transaction or adopt any hedging, trading or investment strategy, in relation to any securities or other financial instruments. This document is for general evaluation only. It does not take into account the specific investment objectives, financial situation or particular needs of any particular person or class of persons and it has not been prepared for any particular person or class of persons.
