Following the invasion of Ukraine by Russian troops last week, the situation has deteriorated quickly and with increasing severity over the weekend. The EU, US, UK and others have announced several sanctions against the Russian Central Bank and state-linked persons. These include an asset freeze for certain Russian individuals and companies (especially financial institutions), travel bans, trade restrictions and financing restrictions preventing the raising of capital in certain foreign capital markets such as the US. Russian equities and the rouble have suffered though the overall long-term impact of sanctions remains unclear.
As part of the response, some Russian banks were removed from SWIFT, the main international payments system, and sanctions were announced against the Central Bank which will impact its ability to use much of its reserves to defend the Russian currency. This week the economic response has further escalated with trading of Russian GDRs/ADRs being suspended. The Russian stock exchange remains closed. Furthermore, the MSCI and FTSE have announced the removal of Russian companies from their Emerging Market classification effective 9 March and 4 March respectively.
What is the impact on our portfolios?
As Emerging Markets Portfolio Manager, Andrew Mathewson explained, the impact on our Emerging Markets portfolios is limited to the direct holdings that we have. Our underweight position in Russia is a result of only two Russian stocks, TCS Group and Lukoil. Our positioning in both cases is intentionally private sector to avoid exposure to state-directed sanctions.
Two of our portfolio holdings with indirect exposure to Russia/ Ukraine are also impacted by the current scenario: software services company EPAM through its employees in Ukraine and Hungarian bank OTP because of its Russian Banking business. 58% of EPAM’s employees are physically located in Russia, Ukraine and Belarus. While our conviction in underlying holdings remains, it is impossible to remove the country risk from our direct exposures. We are monitoring the situation very closely due to the quickly evolving situation and we are assessing the range of possible outcomes and our options for portfolio activity, which is extremely fluid.
Head of Global Long-Term Unconstrained, Zehrid Osmani explained that we have no direct exposure in terms of quoted equities in Russia or Eastern Europe across any of our Long-Term Unconstrained (LTU) strategies and underlying exposure to Russia and Ukraine is also minimal therefore we foresee no change to our LTU portfolio positioning at this stage.
Some Russian banks were removed from SWIFT, the main international payments system, and sanctions were announced against the Central Bank which will impact its ability to use much of its reserves to defend the Russian currency.
Andrew Graham, Head of Asia also confirmed that our Asian portfolios only have a small direct exposure to Russia (Orion) and some indirect exposure (manufacturing operations in Europe e.g. Minth in Germany / Poland / Slovakia; LGES in Poland. While energy costs will likely rise, provided there is no complete loss of supplies, Andrew expects these companies to manage through this. Depending how deep the fallout, this could of course be recessionary for Europe, which would have some demand implications too
Reece Birtles, Chief Investment Officer, Martin Currie Australia confirmed that his investment team has no direct exposure but will also have indirect impact through commodity exports such as wheat, ammonia, aluminium, oil and gas which likely drives increased demand for Australian products.
As Colin Morton, Head of UK Equities explained, the team obviously has no direct exposure to Russian companies, however due to the composition of the UK market there are some sectors that may be disproportionately impacted by the ongoing conflict. Naturally the main exposures are concentrated within large cap equities where 70% of the FTSE 100 earnings are generated overseas, however they are seeing at least some impact across the cap spectrum. In our small and mid-cap UK portfolios, we try to avoid companies whose profits are significantly correlated with commodity volatility. This allows the team to focus on alternative structural growth areas where they believe that risk/return profiles are more attractive. Consequently, we have no direct exposure to any oil, gas or mining companies within our UK small and mid-cap portfolios.
Risk premiums rising – a permanent change or a temporary spike?
In Andrew Graham’s view premiums are rising more due to a path towards monetary normalisation, which began several months ago. One could argue that at the margin, given the incremental inflation/stagflation dynamics that may spin out from the Ukraine situation, the risk of policy error has grown. However, this is only marginal as the gross policy error has already occurred.
While this is a global geopolitical event, the economic realities of it will be felt most keenly in Europe. Russia and Ukraine together are less than 2% of world GDP. Andrew Graham explained that he does not think this is a systemic problem and global banks’ exposure to Russia is only ~US$100bn, so likely too small for this to be systemic either. Additionally, this has been brewing for some time and, certainly now, is already at least partly reflected in asset prices (admittedly, it is difficult to separate this from the other factors affecting markets).
Protracted conflict that impacts supply of energy to Western Europe and imported cereal crops to the world market, will likely add to the current inflation challenges and the increasingly thin “temporary” argument.
Andrew believes that these events, of themselves, are not (based on current assessment) significant enough for a material structural shift in risk premia.
Zehrid Osmani and Reece Birtles also share the belief that the spike in risk premia is temporary whilst uncertainty around a path to resolution is high. They also share the view that this is also a global issue as China territorial claims with Taiwan are also a future risk.
The question of course is how central banks react to another inflationary spike. Our portfolio managers agreed that they will need to hold the course, given higher inflationary pressures as a result of increases in bottlenecks, supply chain disruptions, rising labour costs and higher energy prices. However, they believe that the European Central Bank (ECB) might slow down its pace of hikes, due to geopolitical uncertainty, depending on how the situation evolves.
Inflationary pressures are likely to be more prolonged and last longer than expected. Soft commodities disruption should also be considered, given Ukraine’s agriculture.
Impact on liquidity and trading
Our portfolio managers all agreed that so far there has been no problem with liquidity and any impact has been limited. As detailed above our portfolios have limited/no direct exposure to Russian stocks. Zehrid Osmani explained that for out LTU portfolios this is notable in the Financial sector, where contagion risk is the highest risk to consider. Energy companies force-selling assets in Russia is also an area where our LTU portfolios have no exposure.
They were also in agreement that current pricing reflects a reasonable demand and supply but that markets have been very volatile. Zehrid explained they he would prefer to use a measured and careful approach of risk/rewards before making any decisions, avoiding the knee-jerk reactions which the market is currently going through.
Any further SWIFT restrictions may not have direct implications for the teams but as Zehrid explained, risk premiums would continue to increase and there could be a risk of further contagion and increased systemic risk across the financial sector.
Key risks for the future?
The key potential risks are around further escalation and widening of the conflict. Doubts over whether Western armies would physically intervene in Ukraine remain and the risk to surrounding countries has risen. There would likely be a step up in military spending in Europe, part funded by higher taxes. A large refugee crisis would be manageable but difficult and would put further pressure on already stretched government finances. There are also the risks around energy supplies issues, and disruptions in European economic momentum as a result.
The exact implementation of some of the sanctions, especially the SWIFT ban, is not clear but the impact is expected to be significant. While the market continued to function but with very high levels of volatility and intermittent liquidity, for a time, trading has now been suspended on major stock exchanges. While trading was still permitted, we saw a disconnect between the local shares and the depositary receipts (GDR/ADR), through which we access the Russian market for our Emerging Markets portfolios, for example those in in London continued to trade at a significant discount while the local share’s trading was suspended due to the closure of the Russian stock exchange.
As Andrew Mathewson explained, Russia has further isolated itself from the investment community with major global indices removing Russian equities from their universe including the MSCI and FTSE.
Zehrid and Reece also share the view that China’s territorial claims with Taiwan could also pose a future risk.
On the other side, in Zehrid’s view, de-escalation, truth and agreement between Ukraine and Russia (such as a categoric agreement to not join NATO nor the EU in the long term) could all lead to a major market rally.
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