Market reaction to the crisis has so far been subdued, with small losses over the weekend trimmed back by a rebound in the major indices in early trading today.
Performance of indices since 24 Feb
Source: FE Analytics
Botham (pictured) warns that this respite could be short-lived if, as seems likely, sanctions are imposed on Russia.
“Russia’s chief exports are oil related, so any sanctions will likely drive up energy costs and could transmit a stagflationary shock to the global economy,” he said.“Ukraine is a major wheat producer, so we would expect food prices to be similarly adversely affected.”
Stagflation refers to an economic environment in which inflation rises along with unemployment. Rising oil prices could cause prices to consumers to rise and jobs to be lost as it became more expensive to produce.
Luca Paolini, chief strategist at Pictet Asset Management, suggests that the crisis could even scupper the economic recovery in Europe, one of the strongest markets over the past 12 months.
“Should the situation deteriorate and result in heightened tensions between Russia and the European Union, a major casualty could be Europe’s economic recovery, which is vulnerable given that the region imports roughly 25 per cent of its gas from Russia, half of which flows through Ukraine,” he said.
“Under this scenario, the euro would likely weaken sharply against the US dollar.”
Botham says this extreme consequence is less likely.
“The impact on the supply of natural gas is unclear: it’s really in no one’s interests to turn the flow off,” he said.
“Russia will not want to pre-empt sanctions, Ukraine doesn’t want to anger its European allies or invite further Russian aggression, and the European Union doesn’t want higher energy costs. In a rational world, the gas would stay on until trade sanctions are implemented.”
However, Botham warns that emerging markets could be hit particularly hard, compounding the poor 12 months for the sector.
Fund managers were growing increasingly bullish on emerging Europe for this year before the crisis hit. Sam Vecht, specialist frontiers market manager at BlackRock, said that 2014 could be the year of emerging Europe just as 2013 was the year of frontier markets.
Invesco’s Dean Newman was also particularly positive about the region’s prospects last week.
The emerging markets equity team at Barings says that the region could now be hurt by outflows of external funding, and the MSCI EM Eastern Europe index has already seen a sharp fall.
Performance of indices over 1yr
Source: FE Analytics
“Heightened political uncertainty causes volatility in markets with potential falls in all assets, equity, fixed income and FX as risk premia increase,” the team said.
“Potential outflows from funds can put further pressure on Russian and Ukrainian assets.”
Botham warns that the region could suffer, along with the Indian market which the hugely popular Aberdeen and First State emerging markets funds have significant exposure to.
“On the market front, concerns over a spike in energy and food costs should affect sentiment globally, but particularly assets in the region: central and eastern European markets and currencies will likely suffer, as will countries dependent on energy imports,” he said.
“Within emerging markets, India could be quite exposed on this front. Commodity markets should, broadly speaking, see price increases.”
“Ukraine’s role as a wheat exporter will push up agricultural prices, while uncertainty over oil and gas supply will push up the energy matrix.”
“This could all be supportive in the short-term for some commodity exporters, particularly if they are energy-independent.”
Even if Russia climbs down and sanctions are not imposed, analysts warn that there are serious risks to be aware of.
After weeks of protests shut down the Ukrainian economy, it has been left in a perilous economic situation, with some analysts warning of a potential default.
Oliver Wallin, investment director at Octopus, warns this could have systemic consequences for the global economy.
“Although the country is a minor player in terms of global economic growth, its problems could have serious consequences. Ukraine says it needs $35bn of financial aid to stay afloat, and with Russia having removed funding, it’s down to the EU, US and IMF to step in,” he said.
“Without this funding, a default is on the cards, which would inevitably affect the European banking sector, although it’s uncertain to what degree.”
The crisis underlines the appeal of safe haven assets, which have responded well to the crisis so far. Gold has spiked and long-term gilts have ticked up.
Performance of assets since 24 Feb
Source: FE Analytics
Investors would do well to hold dollar-denominated assets, too, according to Jonathan Pryor, head of FX dealing at Investec Corporate and Institutional Treasury.
“It wasn’t only Ukraine that went into defensive mode yesterday as markets battened down the hatches and opted for safe haven currencies, with the yen and Swiss franc in particular enjoying inflows as a result of heightened tensions about Russia’s next move.”
“So far the dollar has not received quite the support that we might expect from a risk-off move, but if we see an unwelcome escalation of the crisis, the dollar could mount a charge against a large basket of currencies.”
The path forward in Ukraine is far from clear, with Putin sounding more emollient this morning even as his troops remain in situ.
However, Pictet’s Paolini (pictured) suggests that investors should take the opportunity to trim equity exposure after stocks’ recent strong year.He says he remains positive on equities and emerging markets in the medium-term but in the short-term it is time to take some risk off the table.
“The near-term outlook for stocks has deteriorated,” he said. “Economic activity is slowing worldwide, with the US a prominent weak spot. The escalating crisis in Ukraine is another potential source of risk.”
“More broadly, with the recent rally in global stocks showing signs of fatigue, the Ukraine crisis could prove the trigger for a market correction,” he added.
“An escalation of geopolitical tensions may also trigger another sell-off in emerging market assets.”
