The Russian invasion of Ukraine is intensifying despite impressive Ukrainian resistance, with the odds of either side achieving a decisive victory shrinking by the day.
The global response from the West has been decisive: imposing swift sanctions that have inflicted much damage to the Russian economy. On the other hand, the response from the East has been more guarded, bringing into question the future of globalization and world allies.
This uncertainty is reverberating through the global economy and equity markets, bringing one question to the forefront: How do these changing dynamics affect the outlook for global economic growth and financial markets?
In the following article, we examine each of these complex pieces of the global puzzle and provide insight on how each impacts our outlook.
Given Russia’s superior firepower and willingness to attack civilian targets, it remains probable that it will conquer Kyiv, the territory east of the Dieper river and large parts of the coastal region in the south. The conflict is likely to escalate until Russia achieves those aims, because anything less would constitute a clear failure for Putin. However, we do not think Russia will attempt to conquer the western part of Ukraine, despite it turning into a potential haven for a Ukrainian government in exile. We believe Russia will be deterred by western Ukraine’s difficult terrain and proximity to NATO countries, the strength of the Ukrainian resistance (bolstered by support from the West), the disappointing performance of Russia’s forces, mounting economic and military cost and the difficulty associated with holding and policing conquered territory. There are both short-term and medium-term implications for the endgame of this conflict:
- Short-term (3 months) – A Russia that is not about to be defeated nor give up, and has yet to achieve its goals, is unlikely to agree to a ceasefire agreement, let alone engage in serious peace negotiations. Left-tail risk regarding NATO involvement or escalation using unconventional weapons (biological, chemical or nuclear) remains elevated.
- Midterm (6 months) – A Russia that has achieved its aims, but is not inclined to conquer the whole of Ukraine, will need to engage in ceasefire and peace negotiations to wind down the conflict and create a new status quo. If Russia has not achieved its aims, it will have to concede that what is not attainable on the battlefield is not attainable at the negotiating table either (making the hurdle for Russia to stop very high).
Response from the U.S., U.K., EU, Switzerland, Japan, South Korea, Australia and Canada, among others has been stronger, more coordinated, and quicker than many anticipated. The sanctions already in place have devastated the Russian economy, with more announced daily. There has also been a groundswell of self-sanctioning by the private sector. Companies are breaking ties, divesting assets, stopping operations and shelving investments. Before long, Russia will be running a ‘siege economy’ where it will live hand-to-mouth, not unlike countries like Iran and Venezuela. Its Misery Index (the sum of unemployment and inflation) is rapidly increasing, potentially threatening the country’s social stability.
Response from the East, most notably China and India, has been more circumspect. India is clearly hesitant to completely abandon one of its main weapons suppliers and it has strong historical ties to Russia. However, it is also unlikely to outright support Russia and antagonize the West. For China, this crisis is both an opportunity and a threat – and it is seemingly playing both sides accordingly.
The opportunity resides in pushing back against the West and NATO by blaming them for the crisis, refusing to diplomatically condemn the attack or join the sanctions regime. Chinese officials are also amplifying Russia’s disinformation campaign in local media. It seems clear China has its eyes on Russia’s natural resources and is focused on maintaining a close trading relationship.
The threat to China resides in losing Putin as an ally, being seen as abandoning its stance on national sovereignty and territorial integrity and in the economic and diplomatic fallout with the West. Any signs of a formal alignment with Russia will be met by the West with a furious response. For a country whose economy is still heavily dependent on global trade, the unified response from the West against Russia is probably acting as a deterrent to providing opportunistic support. China’s greatest fear is isolation in the face of a united West that stands against it. And it clearly has more to lose than to gain from supporting Russia.
Impact on Economic Growth and Inflation
With greater exposure to both the direct and indirect impact of the crisis, we have lowered our growth outlook for Europe and emerging markets. The U.S. is less exposed and we expect it to be able to weather the storm. The risk of recession in Europe for the full year in 2022 is still relatively low, although a technical recession (two consecutive quarters of negative growth) is possible. To combat the negative impact of higher energy prices, governments are providing fiscal support, and we expect more will be done in the months ahead. The combination of lower economic growth and higher inflation from commodity prices means Europe in particular will go through a short period of stagflation. But we don’t expect it to last long, as commodity prices will either adjust or destroy demand.
The most substantial damage from the conflict is likely to stem from the indirect impact on commodity prices and financial conditions. Financial conditions have tightened in response to the crisis with equity markets and bond markets falling together (and volatility spiking), the dollar rallying and credit spreads widening. This will act as a headwind to growth. Additionally, Russia was the second largest commodity exporter worldwide in 2019 with some important concentrated positions, including:
- Energy: Russia continues to export energy (for now) as Europe pulled back from sanctioning the industry. Prices have come down from their highs but they are still acting as a headwind to economic growth while boosting inflation.
- Metals: Price surges in metals where Russia is a major exporter like nickel and palladium, which are important in EV and ICE car production, are disruptive.
- Agriculture: Big jumps in agricultural prices for wheat and corn will reverberate around the world, especially in emerging markets dependent on Russian and Ukrainian food exports.
A Chinese/Russian Axis?
Although we do not think it is in China’s best interest to overtly support Russia in this war, it is worthwhile to think about what it would mean for Russia if it did.
In the short term, China cannot replace the West as a buyer of everything that Russia produces. The physical infrastructure to transport the goods is simply not there. The train tracks going to China are old and overextended, and even though Russia and China share a border, Beijing and Moscow are 3,600 miles apart. Most of Russia’s economic activity and population is west of the Ural, and most of China’s is on the coast. Even more, with shipping companies unwilling to take Russian goods, and insurance companies unwilling to insure it, there is no way China can step in with size in the short term.
Of course, that picture changes when we extend our time horizon. Infrastructure can be built, trade routes opened and bilateral financing arranged. And there is plenty of appetite in China for much of what Russia produces. However, even if we extend the timeline, the loss of western technical expertise will be keenly felt in Russian production capacity and China will be a cautious actor. As a country, China is much more exposed to our globalized world and China will fear an acceleration of the existing trend of supply chain differentiation away from it.
Even though the crisis in Ukraine will deepen the rift between the East and West, we do not anticipate an overt Russia-China axis in the short term. Over time (5-10 years) that can change, and Russia will surely tilt more to the East out of necessity, but the risks and physical limitations mean it cannot be done in the short term.
Our Outlook for China
China’s equity market has become increasingly volatile in the wake of news regarding Covid-19 lockdowns, China’s role in the Russia-Ukraine war and the ongoing conflict between Chinese and American regulators regarding auditing requirements. Below, we take a closer look at each of these issues.
The recent rise in Covid-19 case numbers in China is a major force behind equity market volatility. Though new case numbers are not that concerning, in the context of the government’s strict zero-Covid policy, any rise will have repercussions stemming from lockdowns. While the immediate impact of lockdowns is likely to remain contained, they still act as a headwind to growth and a tailwind to inflation. The bigger concern, however, is that the Omicron variant is simply too contagious to stop and that lockdowns will spread alongside it, causing much greater damage.
China’s government is not helpless in its ability to counteract the negative impacts of its zero-Covid policy. For example, recent commitments to provide more fiscal and monetary policy support yielded some equity market relief. Early estimates from the budget indicate a sizeable swing in fiscal thrust from -2% in 2021 to +2% in 2022. And expectations are the People’s Bank of China (PBoC) will announce more interest rate and reserve requirement cuts soon in an attempt to boost credit growth. Even so, the question remains whether the government will act quickly and aggressively enough. We will maintain a cautious outlook until we get firm confirmation that the government is acting decisively and the risk of Covid-19 disruption dissipates.
China’s decision to neither condemn nor support Russia has escalated tensions between the West and China. Multiple stories regarding China’s alleged knowledge of the impending invasion, its backing for Russia in local media, and the accusation that it is willing to provide support to Russia have concentrated Western minds on China as a potential adversary in this conflict. Already, the West has made it clear that it will wield its sanctions weapon against China too should China help Russia skirt sanctions or otherwise provide support. As a result, Chinese equity markets have become worried that the risk of economic warfare between China and the West is rising.
Given China’s exposure to global trade, and the difficulty of supporting Russia in the short term, it seems clear that China has much more to lose from supporting Russia than it has to gain. However, that does not mean it is not a risk we have to take seriously. There are also the direct and indirect impacts weighing on China’s equity market. Lower economic growth and higher inflation are a clear headwind. And as a major consumer of energy, metals and agricultural goods, China is feeling the pain of higher commodity prices.
A third headwind to the Chinese equity market has been the long-running conflict between Chinese and American regulators regarding the auditing requirements of Chinese companies using the American Depository Receipts (ADR) structure to list in the U.S. and raise capital.
To protect U.S. investors, the U.S. Securities and Exchange Commission (SEC) is demanding complete access to companies’ books, while China’s Financial Stability and Development Council (FSDC) explicitly forbids such access. The SEC may target up to 270 groups if they don’t hand over audit documents, spooking the broader equity market. The ADRs of the companies involved have lost much value and become virtually uninvestable. Investors who want to maintain exposure to Chinese stocks are pivoting to its onshore market. The conflict, however, could still be resolved if the SEC and the FSDC reach an agreement.
Looking ahead, for as long as the Chinese government sticks to its zero-Covid policy, refuses to abandon Russia diplomatically and fails to aggressively support domestic growth, we will remain cautious on the asset class.
What Does This Mean for You?
The conflict in Ukraine is still intensifying and there is a high likelihood that the fighting is going to get worse. Whether or not Russia will be able to overcome the fierce Ukrainian resistance is an open question, and the ceasefire negotiations might yield an unexpected result. In the meantime, the economic, inflationary, financial market and geopolitical fallout is becoming murkier by the day.
Against a background of less growth, more inflation, heightened financial market volatility and growing uncertainty regarding the role China is going to play, we encourage investors to revisit your asset allocation to ensure it is in alignment with your goals and risk tolerance. Doing so will ensure you have enough Risk Control (high quality bonds and cash) to fund your goals during times of prolonged volatility.
By staying invested in Risk Assets (equity and equity-like assets) despite economic and endemic uncertainty, you can avoid falling victim to the behavioral biases that tend to manifest during times of market weakness. If you are concerned about the volatility of your risk-asset portfolio, consider moderating your risk by substituting some of your existing equity exposure for low-volatility strategies, higher quality or higher profitability equities, and dividend-paying stocks.
As always, we are closely monitoring the situation and will continue to keep you updated on the latest developments.