MUNIX WEEKLY
Looking through the fog of war
The Ukraine crisis is causing considerable volatility in financial markets. On some days traders have sold over-stretched positions or bought back cheap stock, leading to 3-4% moves in share prices. On other days there has been apparent calm as investors reassessed the latest news on sanctions or military developments.
The only thing that can be said with certainty about the Russian invasion is that the outcome is very uncertain. At one extreme there could be peace, of some sort, within a week, while at another extreme the war in Ukraine could last months, and even spill over into other countries through such dangerous areas as cyber-warfare or a cessation of Russian gas exports to Europe.
It is becoming clearer by the day that there will be economic consequences for all parties. The only question is how bad. The shock for the West was that Putin did invade. The shock for Putin must be the rapid and aggressive nature of the Western response. Massive retaliatory sanctions are being rolled, especially related to the access by Russian banks to the SWIFT payments system and also restricting the central bank’s access to its international reserves. Foreign policies are being overturned overnight, such as the EU agreeing to ship weapons to the Ukraine, or the turnaround in defence policy in Germany, or Switzerland breaking its traditional banking neutrality.
The implications of the hits to trade, to corporate profits, to business and consumer sentiment are only starting to be seen. BP and other oil companies will take a loss from their divestment of Russian operations, Apple from its decision not to sell its goods in Russia, investors who discover their Russian assets are worthless. Economists are guessing that the impact to the Russian economy could be of the order of 5% of GDP, pushing it into recession. Although Russia is only the 11th largest economy in the world, slightly smaller than Canada or Korea, the loss of business will feed through to other countries. Early estimates are that European and UK GDP economic growth could be between 0.5-1% weaker in the coming year, with US GDP perhaps 0.25-0.5% lower.
Such estimates are highly uncertain. Central bankers will face a difficult task in coming months as they cope with a stagflationary shock. Higher energy costs, exemplified by oil approaching around $110-120 per barrel, will keep headline inflation higher for longer. The squeeze on household incomes, on top of previous announcements about heating bills and tax increases, will be significant. It has not been a surprise to see as sharp decline in UK consumer confidence in recent weeks.
Money markets are starting to price these changes into the outlook for official interest rates. Although the path is still expected to be upwards, with the Bank of England and Federal Reserve raising rates later in March, the shape of the cycle does look a little different. For example, the terminal rate for UK interest rates has been lowered by about 0.7% over recent weeks, while the Fed cycle is expected to be about 0.5% and the ECB cycle about 0.35% lower than previously thought. The net result can be seen in lower 2 and 10 year government bond yields (see table below). German yields have even returned to zero and threaten negative territory once again. For those who wanted to take advantage of even modestly higher yields, the window of opportunity was rather short. Longer-term implications are very unclear. Has Putin made the same mistake as Saddam Hussein did when he invaded Kuwait in 1990? How much pain are Western economies happy to accept in the course of defending Ukraine? Time will tell but market volatility could be considerable before that question can be answered.
Bond yields at the time of writing:
USA 2 year = 1.47% 5 year = 1.66% 10 year = 1.77%
UK = 1.10% = 1.02% = 1.26%
Germany = -0.7% = -0.3% = 0.0
Andrew Milligan is an independent economist and investment consultant. This note is offered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making