As events continue to unfold in Ukraine at a rapid pace, Emerging Market Equities portfolio manager Nick Price reviews recent developments and looks at the key implications of recent sanctions on Russia. He provides an insight into his current positioning in Russia and the broader investment outlook from here.
- The Ukraine conflict and related Russian sanctions are likely to have a significant inflationary shock on the global economy that persists longer than previously anticipated.
- SWIFT restrictions will put huge pressure on Russia's banking system. Additionally, the Central Bank of Russia has now stepped in, suspending distribution of dividends and coupons to non-Russian residents.
- Our EM equities portfolios were generally overweight Russia going into this crisis. Our exposure has come down, but we will avoid knee-jerk reactions to fast moving events.
Central Bank sanctions
At the outset, it's important to say that we don't underestimate what the people of Ukraine are going through at this time - the tragic loss of life, human suffering and destruction.
This is a dynamic situation and we have seen some significant sanctions imposed on Russia. These include sanctions on the Russian Central Bank that will impact its ability to use foreign exchange reserves to support the rouble. Russia has some US$640 billion of forex reserves, the fourth largest in the world. This is a very strong position which in hindsight, was probably deliberate. However, these sanctions make it very difficult for the Central Bank to intervene in the forex markets and provide a level of stability. As a result, we are seeing the rouble move around enormously. The initial response from the Russian Central Bank has been to increase interest rates from nine and a half to 20%.
We have also seen the decision to exclude some Russian banks from the SWIFT messaging system, which facilitates international payments. The Russians have their own analogue system, as do the Chinese, but these are peripheral in the overall framework.
While this does significantly restrict access, it is not all encompassing as the West still wants to buy Russian gas, oil, grains and other commodities. Consequently, this is not a universal ban in the way it was for Iran, for example. Over time, Russia will start to use alternative systems and we expect this to push Russia and China to trade more closely together as the latter is a natural counterpart for buying things like commodities.
Russia has a history of bank runs and the Russian people are deeply mistrustful of the system. Hence, there will be extreme pressure on the banking system and with that a strong need for banks to try and conserve capital. Additionally, the Central Bank of Russia has now stepped in, suspending distribution of dividends and coupons to non-Russian residents.
In terms of capital markets, both the bond market and the equity secondary markets are open in theory, but in practice, we are seeing various points of closure. We have seen this before, mainly in 2008-2009, and in my view what we are currently seeing is not true price discovery.
Russia accounts for 12% of the world's natural gas and 45% of Europe's natural gas and 60% of both Germany and Italy's natural gas supply. Russia also produces around 12 million barrels of oil daily, compared to around 100 million produced globally. To put this in context, Iran produces 2 million barrels, so Russia produces nearly six times that - it is the equivalent of Saudi Arabia going off the market. Russia and Ukraine combined are a quarter of the world's wheat, they contribute 40% of the world's potash, 25% of the world's ammonia, 12% of urea and 20% of corn.
Consequently, this uncertainty will likely result in a significant inflationary shock that may persist longer than might have been previously anticipated. This is where the duration of the conflict comes into play because the longer it lasts, the longer consumers will have to bear higher prices.
My own view is that global central banks will no longer be able to maintain their hawkish stance on interest rates. We may see an injection of liquidity into markets to ameliorate some of these effects.
In terms of general contagion, I see this as having broad implications for equity markets. In Europe, oil and gas prices constitute some 20% of consumer disposable income so Europe's position is as tenuous from the conflict as EM - if not worse.
Key stock positions
Going into this conflict, we have been overweight Russia. One of the attractions of the country was the very cheap valuation and the energy exposure. Putin's aggression has clearly taken everyone, including markets, by surprise.
Sberbank and Gazprom are two key names in the portfolio, with the former looking the more vulnerable of the two. Sberbank is the largest bank in Russia with a 50% deposit market share and it remains extremely well capitalised with a very prudent risk framework. But the sanctions and broader uncertainties mean that this period is likely to be extremely challenging.
On Gazprom, we have not seen any sanctions on gas yet. The rouble has plunged to new lows, and a sizeable portion of its costs are in roubles. Gas prices are at all-time highs, profits and cash flows are at record levels. We therefore believe the investment thesis on Gazprom remains sound, especially in the context of its high yield. We will, however, continue to monitor the stock very carefully over the coming days.
Our portfolios were generally overweight Russia going into this crisis. Today, our exposure is lower than it has been but it's important to state that we have a duty to act in an orderly way and in the best interests of our investors. As such, we will continue to avoid knee-jerk reactions to fast moving events.
The value of investments can go down as well as up and investors may not get back the amount invested. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. The use of financial derivative instruments for investment purposes, may expose the fund to a higher degree of risk and can cause investments to experience larger than average price fluctuations. Increased and more complicated use of derivatives may result in leverage. In such situations performance may rise or fall more than it would have done otherwise. Investors may be exposed to the risk of financial loss if a counterparty used for derivative instruments subsequently defaults. Emerging Market portfolios are likely to have high volatility owing to its portfolio composition or the portfolio management techniques. Currency hedging may be used to substantially reduce the risk of losses from unfavourable exchange rate movements on holdings in currencies that differ from the dealing currency. Hedging also has the effect of limiting the potential for currency gains to be made. Investors should note that the views expressed may no longer be current and may have already been acted upon. The shares in investment trusts are listed on the London Stock Exchange and their price is affected by supply and demand. Investment trusts can gain additional exposure to the market, known as gearing, potentially increasing volatility. Reference to specific securities should not be interpreted as a recommendation to buy or sell these securities and is only included for illustration purposes. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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