There is huge uncertainty over what happens in Ukraine and what the collateral damage to the world economy will eventually be. The conviction is that growth is going to be weaker and inflation higher. On top of that, the outlook for monetary policy is not as clear as it was. And to top it all we face a potentially changed long-term outlook regarding the cost of security. Even if you want to trade, liquidity is poor. So, the dollar and US assets – where liquidity is most ample –are benefitting and will continue to do so until the conflict takes a different course.
Russia cut off
After a week of fighting in Ukraine we are no clearer to knowing what the end-game looks like. A significant volume of sanctions have been imposed against the Russian state, some Russian enterprises and some individuals. In total, the sanctions have largely cut off Russia from the international financial system. Limited access to the SWIFT international bank messaging system has been preserved to allow payments for energy exports and, I presume, essential imports. However, asset and transaction freezes make it very difficult for Russia to fund in foreign currency. As such the ruble has sunk and domestic interest rates have skyrocketed. Inflation is likely to soar, cutting living standards of ordinary Russians. It’s probably not too much of an exaggeration to suggest the Russian economy is collapsing.
What about the future?
Whether that ultimately plays into the military sphere remains to be seen. News reports suggest the scale of the onslaught against various Ukrainian cities has increased. Efforts at finding some kind of ceasefire look likely to increase in order to provide some respite to the suffering of the local population. What is hard to price is an outcome in which Putin appears to have “won” by gaining control of large parts of Ukraine and forcing the current government to leave Kyiv. That is not the only scenario but is one in which Russia would remain ostracized from the international community.
This provokes some consideration of longer term issues around energy and political security in Europe and the potential of the enlargement of NATO to take in states like Sweden and Finland. There are echoes of the Cold War and, indeed, many geo-political analysts suggest that the west should prepare for such, as long as Putin remains in power in Moscow and Russia remains hostile to the idea of any further extension of NATO membership.
Remember the 1980s?
The end of the Cold War in the 1980s, brought about by Presidents Reagan and Gorbachev, was hailed as economically significant because it delivered a peace dividend to the world. The thawing of relations between east and west and the collapse of the Soviet Union meant less need to preserve very high levels of defence spending. In 1980, the defence spending amounted to 6.8% of US GDP. That had fallen to just above 3.0% by 2000 where it has roughly remained since. The same pattern has been seen in France and the United Kingdom with defence spending at less than 2% of GDP in those two countries in recent years (Source: World Bank, Macrotrends).
The peace dividend meant less spending on defence, creating the room to spend more on civilian activities, reduce taxes and boost public investment. Whether or not all those things happened in a consistent way is open to debate but there is also the argument that reduced defence spending and the reduction in tensions associated with the end of the Cold War contributed to the four-decade long decline in inflation (it was easier for globalization to take hold when there was no Iron Curtain down the middle of Europe).
In the absence of surely knowing that Russia will be governed in a more democratic, just and internationally responsible way in the future, it seems that we are likely to see some reversal of the peace dividend. In a historical change of heart, Germany announced it would increase spending on defence. Other nations in Europe are likely to have to do the same to make democratic Europe safe from further Russian expansionism. A return to the levels of military spending as a share of GDP that prevailed in the 1980s is unlikely, but some increase compared to levels in recent years appears on the cards.
There are some longer-term investment considerations here. First, spending on military hardware, logistical systems, munitions and technology will increase. There will be beneficiaries from this in the aerospace and defence, transportation, and technology sectors. This will pose questions from an ESG point of view. Modern warfare is not just about tanks and missiles – although the current conflict reminds us that they are still at the core of achieving territorial ambition – but also depends on technology and its application to cyber-warfare. Identifying assets that contribute to those activities may not be so straightforward.
The question of what increased military spending means for government spending and deficits also needs to be considered. Are we talking about a multi-year increase in spending to allow western nations to have a military defence capability that matches the perceived aggressive capabilities of countries like Russia? An additional 1%-2% or more of GDP spent on defence is not inconsiderable. It could add to government borrowing needs and contribute to higher interest rates in the future.
Don’t delay the benefits of the energy transition
Achieving greater energy security is also going to require accelerated investment in alternatives to a reliance on Russian gas and oil. Of course, that means more investment in renewables (I read an encouraging interview with the CEO of an Italian energy company this week talking about utilizing solar energy in the Sahara to generate green hydrogen that could be pumped through existing pipelines to Europe). It may also mean more investment in nuclear energy and facilities for importing energy sources like LNG from other parts of the world (the middle east in particular). None of this can happen quickly hence the huge supply risk premium in the price of energy today. That is contributing to higher inflation and it may mean a permanently higher inflation risk premium embedded in interest rates. My take on the energy transition is that ultimately it leads to lower energy prices (good for growth) and more energy security. The disruption to the transition by the war and the need to combat higher prices in the short-term delays those benefits.
Real yields lower again
None of this is obvious today. Real yields have moved lower since the start of the war and the markets have marginally been driven more by the flight to quality trade than the inflation and higher rates narrative. Best performing asset classes since the invasion started have been Euro inflation linked bonds, long duration government bonds, mid-cap US equities, the Nikkei and value stocks more generally. The worst have been European equities, Asian credit, and emerging market fixed income more broadly (even though Russia and Ukraine combined were a small part of the indices). From the date of the invasion to the close of markets on March 3rd, the difference between Asian high yield performance and European inflation linked performance was 6.5%!
Difficult markets, safe havens remain attractive
In general, financial markets are orderly. Liquidity is poor, reflecting uncertainty and the impact that sanctions are having on the plumbing of the global financial system. Within equities, the US has outperformed Europe, and the energy sector has performed best and financials worst. The super-economic rent in energy prices and the potential for asset impairment, defaults and increased provisioning in some banks explains that divergence. When the relief trade comes, that pairing is likely to reverse especially with central banks having to take a more cautious approach to removing monetary accommodation and the majority of the banking system have limited exposure to Russia.
But today is not the day to look for the relief trade. Things could still get worse and that could be still reflected in further downside to equities, the Euro and credit performance. US Treasuries and the dollar have benefitted from global uncertainty so far and, despite the obvious political concerns about inflation represented by the comments made during Chairman Powell’s appearances in Congress this week, geo-political uncertainty will continue to support them. The west, led by the US, won the Cold War and money banks on US hegemony remaining unchallenged over time.