Where do we stand?
The Russian economy is likely to be severely impacted by the sanctions: on top of a possible confidence shock, the Central Bank of Russia has raised its key rate to 20% (from 9.5%) to slow down deposit withdrawals and counter the ruble (“RUB”) depreciation (the RUB has already depreciated by roughly 50% against the dollar since mid-February). The CBR has also decided to put in place some capital controls, notably temporarily banning foreigners from selling securities.
The war in Ukraine will impact world growth as commodity prices have surged (not only energy but also food and metals), but also because of renewed tensions on supply chains: Ukraine supplies more than 90 percent of U.S. semiconductor-grade neon while more than a third of palladium, a rare metal also used for semiconductors, is sourced from Russia. Some countries (in particular African and Middle East countries depending on Russia and Ukraine for wheat) are likely to be more severely impacted than others. But we continue to believe that the global recovery from the pandemic will not be fully derailed.
Our macro scenario for the Euro area
In Europe, risks on growth are skewed on the downside and we cannot rule out a “worst-case” scenario in which a full cut from Russian gas would trigger a recession. Still, for the time being, sanctions have been narrowly targeted in order not to directly affect Europe’s energy imports from Russia. Moreover, some offsetting fiscal measures have been decided to soften the blow – for example, Italy has already approved a €8 billion aid package for energy and auto sector relief, Germany has approved a €13 billion package to help households cope with surging energy prices, France has put temporary caps on regulated energy price hikes since late 2021. If tensions on the energy market do not worsen materially, Gross Domestic Product growth in the Euro area could still be above 3% in 2022. In this environment, the ECB is likely to stick to its plan and to cautiously remove its accommodative stance.
The US economy is less exposed to Russia and the recovery is unlikely to be derailed. Admittedly higher inflation will be a drag on consumption, but excess savings as well as higher energy related capex will provide some buffer. With an economy at maximum employment, and inflation elevated, the Federal reserve will lean in the direction of a neutral stance and hike its interest rates several times towards 2.25 by end of 2023.
What risks are currently priced in by financial markets?
Equity volatility, particularly in Europe, has entered its highest level, which quite logically reflects the stress linked to the total invasion of Ukraine by Russia, an event that still seemed unlikely at the beginning of February. In terms of the absolute level of volatility, we have not yet reached the peaks known during major crises, which would be a signal of financial market capitulation.
The equity indices have corrected since the beginning of the year. As of 15th of March, the Euro zone is down around 15%, more or less in line with the American and Emerging markets. The FTSE100 (United Kingdom) is the most resilient index, only down by around 5%. As for rates, their volatility remains extremely high. Rates fell sharply following Russia invasion of Ukraine and rebounded strongly in the wake of the ECB meeting, reacting to increasing inflationary pressures and the determination of central banks to fight inflation. Finally, commodities, which are the main vector of contagion of this crisis to our economies, have reached new highs (oil price, natural gas in Europe, agriculture, disruption of the nickel market..) before falling back this week. Volatility and counter movements make this market difficult to read and anticipate.
So, what scenario should we take into account today?
If this conflict is resolved quickly and commodity prices continue to fall, then the overall economic damage could be quite limited. The markets could return to their growth trajectory: inflationary pressures would fall and the economic environment would improve. Central banks could pursue their normalization path more serenely. In this context, the most “value” regions such as Europe and Japan could benefit the most from this rebound. Conversely, the deterioration of the current situation could weigh a little more on growth and inflation forecasts, reinforcing the risk of "stagflation" leading ultimately to a "recession". In this context, the allocation to risky assets should be reduced, while the yield curve should flatten before inverting. The outcome remains thus binary, and uncomfortable for investors. This also explains why outflows from equities have been limited for now. Armed conflicts do not have a lasting and significant impact on the markets, except when they lead to an energy crisis... which is at stake today.
How have we adapted diversified portfolios since the beginning of this war?
Since early February, we have reduced our exposure to equities by increasing the level of protection in our portfolios. We are actively managing their exposure by positioning for a potentially binary outcome in this crisis, acknowledging upside and downside risks. We increased our exposure to gold, to certain currencies such as the USD, the Yen and the Swiss Franc. We also increased our exposure to commodities (mining and US oil sector) and cut our exposure to financials, the hardest-hit sector since early February. We are maintaining a flexible and pragmatic approach until we have more visibility on the outcome of the war.