Our global equities team discuss the main direct and indirect consequences of the Ukraine-Russia crisis for stocks.
Read this article to understand:
- The effect of sanctions on Russian stocks and beyond
- How the crisis is adding further complexity to global supply chains
- Where there are relative safe havens in equity markets
The Russian invasion of Ukraine, which began on February 24, has already had a significant impact on economies and financial markets, extending well beyond the two countries involved.
In this Q&A, Alistair Way (AW), global head of equities; Andrea Carzana (AC), global equities portfolio manager and co-manager of the Aviva Investors Climate Transition Global Equity strategy; Jonathan Toub (JT), global equities portfolio manager and co-manager of the Aviva Investors Natural Capital Transition Global Equity strategy; and Will Malcolm (WM), global equities portfolio manager, discuss the immediate and longer-term implications of the crisis for their asset class, particularly on global supply chains and other second-order effects.
In doing so, it is important to repeat our public position on the conflict: First and foremost, we are extremely concerned at the events unfolding in Ukraine and our thoughts are with all Ukrainians at this time. Further details on Aviva Investors’ position can be found here.
What have been the main effects of the crisis so far on equity markets?
JT: It has had a profound impact. The inflationary pressure on basic commodities is quite staggering, and the repercussions are being felt in supply chains around the world. We've seen unprecedented speed in terms of the globalisation of sanctions: to give some context, what took two years to implement against Iran took two days in the case of Russia, which has essentially made it an un-investable market.
There are stranded assets in Russia that are now untradable
There are stranded assets in Russia that are now untradable; huge numbers of international companies and investors are locked into the assets without a clear exit plan. We just can’t predict what will happen to those in future. The net effect is a sea change in the risk premia attached to various financial instruments.
WM: For the most part, the value of all tradeable assets in Russian equities has been written down to zero. That’s not just Russian stocks, it’s also the assets of businesses with interests in Russia. There is little expectation of much residual value in those assets.
Beyond that, it’s the enormity and breadth of second-order effects on supply chains. If we take the extractive and agricultural nature of Russian and Ukraine exports – we’re talking food, materials and energy – these are critical primary production pillars in pretty much everything we do. In truth, we're still working our way through the implications.
There is a big risk of inflationary-driven demand destruction
On the demand side, there is a big risk of inflationary-driven demand destruction, and margin squeezes which could feed through into a loss of confidence on the consumer and corporate side. We are already seeing downgrades in GDP forecasts, and that impacts companies’ profitability expectations. This is all before considering an extension of geopolitical risk into countries like China and what that might mean.
AC: If you step back even before this crisis, there was already uncertainty in financial markets and that is always the big risk for equities. COVID-19 caused massive issues with supply chains; there was a lot of concern around what central banks were going to do and now we have a war on top of that. This adds further complexity to the supply chain issues, in areas like automotives for example.
AW: The markets were already worried about slowing growth, rising energy costs and supply chain disruption. The war, and the tragic humanitarian aspect, has really exacerbated these concerns. At the same time, the equity market overall has been quick to discount a bad scenario. The main hit is to emerging markets, whether by proximity or association, and to Europe because of its proximity to the conflict, the energy supply issues and supply chain disruption. Rationally, you would expect that to feed through into economies and growth, because there are some big moving parts.
We have seen peculiar volatility with some markets experiencing extreme price movements
In terms of the market reaction, we have seen peculiar volatility with some markets experiencing extreme price movements. EM equities has always been a volatile asset class, but it is rare to see share prices move more than ten per cent in a day. When it has happened, there has always been a big company specific event associated with it. Since this crisis began, almost daily we have seen a handful of companies that have been up or down in the double digits.
While I don’t see that continuing, the changing composition of the equity investor base – with fewer long-term fundamental investors and more retail, macro and hedge fund money – does mean we are seeing a more extreme and often negative reaction to events. The focus on geopolitics and looking for binary outcomes has led to massive dispersion between countries and asset classes viewed as relatively safe and others put into a risk-aversion basket.
The market is not focusing on bottom-up stock analysis at present, but this will lead to anomalies and opportunities in stocks where arguably the long-term prospects have improved but that isn’t reflected in valuations now because of risk aversion.
Has the recent sell off been an indiscriminate ‘risk-off’ move, or more nuanced? Where are the current ‘safe havens’ in equities?
JT: Clearly the most direct impact has been felt in companies with the greatest Russia exposure, but outside of that it is more nuanced. In emerging markets, the Middle East is a relative safe haven because it is positively exposed to the move in oil and chemical prices. And more broadly, the shift in policy in Europe is supportive for the renewables sector.
There is concern around stagflation, which cuts across all markets
But if we look globally, things look quite fragile. US retail had already been weak in recent months due to inflation concerns. Now, there is a much bigger concern around stagflation, which cuts across all markets.
Another point I would make is around the risk of sanctions, particularly towards countries perceived to be supportive of Russia. There are concerns China, for example, could face similar sanctions and that has led to a phenomenal dislocation for Chinese entities with overseas listings.
WM: As investors, we try to understand whether there is some logic in the scale and speed of the market moves, which might appear unfathomable. Historically, Russia was well rated from an earnings and valuation perspective; that was until Putin moved the country in a different direction, particularly with the expropriation of private assets. That event caused a massive derating of Russian assets, which has endured for 15-20 years.
So, when people looked at the Russian market before this event and were asking why good companies trade so cheaply, the answer was the huge discount because of the government. The sanctions against the country can be seen in that context as the ultimate fat tail risk.
Are sanctions against China a genuine risk? That would seem an extreme option.
WM: Remember we’ve already seen incremental sanctions imposed on China by the US through the trade war. It’s a delicate situation for China in how it balances its economic interests globally with its relationship with Russia, who it shares a 4,000-kilometre border with. China appreciates the implications of being seen as a ‘bad agent’ by the US and others.
Full-scale sanctions against China would be problematic, particularly for Europe
AC: Full-scale sanctions against China would be problematic, particularly for Europe. Europe is an export-led economy and China is a big trading partner. It needs China; it couldn’t afford to impose similar sanctions against China at this point in the cycle, especially given the current energy crisis and economic concerns.
AW: Incrementally there are extra controls from the US on Chinese tech companies that would restrict their ability to support Russia. Suggestions from the Chinese authorities to state-owned companies to buy or assist Russian materials companies were received very negatively internationally as putting China firmly on the wrong side of the geopolitical divide. You would expect China to tread a very careful line on that.
Many international businesses have announced they will stop doing business in or with Russia. How significant is this in a broader context?
JT: We got a sense of this when Shell said it was going to buy a load of Russian oil at the start of March but decided not to go ahead after huge pushback from consumers. We’ve seen a lot of companies announcing they’ll stop doing business in or with Russia, which is OK for those who generate maybe five to ten per cent of revenues there.
Emerging market companies are not sure how to proceed
But that is not necessarily a universal view as there are other companies with more significant capital investments in Russia. In particular, emerging market companies are not sure how to proceed. Take India, for example; they still haven’t imposed sanctions and are keen to do business with Russia. Hyundai Motor Group is one of the largest players in the Russian auto market – it has factories there and people on the ground, so this is all unchartered territory.
Then you have the ESG overlay investors are putting on due to human rights abuses and a very sizable population who have lost or will lose their jobs as a result of international businesses pulling out of the region, in Russia as well as Ukraine.
AC: Russia is still a very large economy, so there is a tangible impact to virtually every global company. Markets were quick to discount Russian exposure down to zero in many cases but figuring out the second-order impacts is where things get very complicated.
Russia is still a very large economy, so there is a tangible impact to virtually every global company
One of the biggest questions is around what happens to the foreign-owned (or part-foreign owned) Russian assets and the Russian-owned overseas assets that are currently stranded. For the former, the question is whether other foreign players could be allowed to take on those assets or whether they will be expropriated and effectively nationalised.
JT: If you take an example like Sberbank – it’s a huge bank, but highly leveraged. If it continues to be cut off from the international financial system, you could quickly see its value go down to zero quite easily. Compare that to Lukoil, which continues to pump out oil. We know there is a market for that oil – Iran has had sanctions on it for several years, but still pumps out millions of barrels of oil a day. But because of the current situation, Lukoil has gone from a company valued around $80 billion to one valued at less than $1 billion.
What are the other main second-order effects?
AW: One key theme, which was already well underway as a result of COVID and trade tensions, is further localisation of production, with companies seeking to be less impacted by global supply chain constraints by structurally holding higher levels of inventory. I think this will accelerate, not just in the obvious areas like energy, but industrial supply chains in general. The European auto market, for example, is particularly sensitive to Russian supply disruption, which is why we have seen such a negative impact on the likes of Valeo and Michelin.
Longer term there could be the risk of a less efficient global production base, excess capacity and structurally lower returns
In industrials and tech, the rational thing from a country perspective is to build up internal capabilities and support national champions. So, another key theme will be countries investing to catch up with best-in-class technology and increasing local production to insulate their companies and economy from events like these going forward. The implications of this are a continuing global capital expenditure boom for companies supplying key equipment, but longer term there could be the risk of a less efficient global production base, excess capacity and structurally lower returns.
AC: Aside from localisation, including onshoring of energy, the other trend from a policy perspective is around consuming less. If you take construction for example, there are policies in place to make buildings more energy efficient. In the UK, we’ve seen subsidies for heat pumps and I expect more policy support in the EU and the US in areas like renewables, which could be a major tailwind over the longer term and great news from an ESG perspective. However, we have to also acknowledge it will take many years before the installation of renewable capacity can be counted on.
WM: Just to expand on the localisation dynamic, I wouldn’t be surprised if we see clearer geographical blocs emerge rather than purely domestic supply chains. But we also have to keep in mind there are Russian and Ukrainian exports that you simply can't substitute out right now, particularly when it comes to extractive and agricultural output.
As Andrea said, the shift from hydrocarbons to renewables and energy self-sufficiency will take many years. In the meantime, even if it’s not Russia, we’re going to be dependent on other geographies to supply energy and other goods.
Further freight shortages and increasing shipping rates add to the inflationary pressures, and someone has to bear that cost.
JT: We have already seen bifurcation in terms of Western versus Eastern policy, and this latest crisis is just going to encourage further fragmentation. What happens with Western trade and foreign policy will be critical.
Shifts in policy stances can have massive consequences and is something investors need to remain mindful of
It is interesting the markets have been reacting to potential sanctions against China because of a perception it is supporting Russia. At the same time, India has refused to condemn the invasion, is talking about settling Russian oil in rupees and is still acquiring military equipment from Russia. At the moment, the West seems to be turning a blind eye to this given the current focus of US foreign and domestic policy. But as we’ve seen, shifts in policy stances can have massive consequences and is something investors need to remain mindful of.
Just to add a couple more points. First, Ukraine is a huge exporter of soft, agricultural commodities which is a significant risk given that planting season is upon us and there is no one out there in the fields planting, let alone the likely disruption to harvests and export of the produce.
Second, it is difficult to underestimate the impact of sanctions on other markets. There are reports that farmers from Latin America to the UK won’t plant certain crops because of the preventative cost of fertiliser, seeds, oil and logistics on underlying profitability.
This crisis has worsened concerns around inflation. What are the implications for equities?
AW: In a relatively short space of time, we’ve moved from an environment with limited wage and commodity input price pressure to one that is almost the polar opposite, where we have to be acutely focused on pricing power. This is going to be critical for security selection, particularly avoiding companies whose margins are going to be under pressure in the current environment.
There’s a decent degree of pricing power in areas like tech and semiconductors
There’s a decent degree of pricing power in areas like tech and semiconductors, but it could be a different story for normal consumer goods companies.
JT: Over recent years, luxury goods producers have been able to pass on higher costs without too many problems. This is really a demand rather than supply issue, and you would expect those who can afford to spend money on luxuries will still be able to do that. At the other end of the spectrum, we’re already seeing companies in food packaging and consumer staples come out and say it's going to be difficult to pass on higher prices, which will hit margins.
Inflation was already a key consideration in our decision making before this crisis; I see nothing in the foreseeable future to change that.