The Ukraine Crisis and the Markets

The invasion of Ukraine by Vladmir Putin’s Russian Federation troops will have a devastating effect on the people and infrastructure within Russia’s unfortunate neighbor. Death and destruction are certain.

The effect on the geopolitical landscape could be equally devastating, as Putin seeks to reclaim former Soviet territory. Putin’s actions have already ratcheted up tensions between his nation and the West in ways not seen since the height of the Cold War, replete with nuclear saber-rattling on the part of Russia.

With the fog of war, it is difficult to say with any certainty what will be the end result from Russia’s aggression. We look at the crisis in regard to its economic impact. That impact will be felt across a number of markets, from wheat and energy prices and the region’s sovereign-dollar bonds to safe-haven assets and stock markets. However harsh the effects, Bowen Asset Management believes the immediate impact will be nowhere near the sudden economic shocks caused by the global coronavirus pandemic lockdown in 2020.

Russia is a key supplier of the oil, gas and raw materials that keep the world’s factories running. But unlike China, which is a manufacturing powerhouse and intimately woven into intricate global supply chains, Russia is actually a minor player in the world economy.

Energy

Russia is the world’s third-biggest oil producer and second-biggest producer of natural gas, ranking among the top energy suppliers to the U.S. and China, the world’s top two economies. In 2020, Russia provided seven percent of the U.S. petroleum and crude oil imports, making it our nation’s third-biggest supplier, alongside Saudi Arabia.

Europe gets nearly 40 percent of its natural gas and 25 percent of its oil from Russia, mostly coming through pipelines which cross Belarus and Poland to Germany, as well as a network through Ukraine and the Nord Stream 1 pipeline which runs directly under the Baltic Sea to Germany. As a result of the invasion, Germany said it would halt the newer Nord Stream 2 gas pipeline from Russia.

As President Biden has warned, Americans are likely to see higher gasoline prices due to the Ukraine crisis. However, because the United States is itself a large producer of natural gas, those price increases will not nearly be as steep and as broad as elsewhere.

Energy prices had already been soaring in recent months amid a confluence of factors, including the pandemic and limited supply in addition to the growing tensions between Russia and Ukraine. Oil prices surged past $100 a barrel for the first time since 2014 on Feb. 24, 2022, the day Russia began its attack.

The demand for oil might add momentum to negotiations to revive the 2015 Joint Comprehensive Plan of Action to curb Iran’s nuclear program, an agreement abandoned by the Trump administration in 2018. Iran, which is estimated to have as many as 80 million barrels of oil in storage, has been locked out of much of the world’s markets since then. An announcement expected soon on a new deal to lift sanctions in exchange for renewed controls on uranium enrichment. Enforcement of existing sanctions has already slackened in the last year, with increasing volumes of Iranian crude shipped to China.

The Ukraine crisis is also contributing to a reassessment of the global economy’s structure and concerns about energy self-sufficiency. The pandemic has already highlighted the downsides of far-flung supply chains that rely on lean production. Now Europe’s dependence on Russian gas is spurring discussions about expanding energy sources, which could further sideline Russia’s presence in the global economy.

The Food Supply

Ukraine is projected to be the world’s third largest exporter of corn in the 2021-22 season and the fourth largest exporter of wheat, according to International Grains Council data. Russia is one of the world’s top wheat exporters. Russia and Ukraine together account for nearly a quarter of total global wheat exports. Prices could spike following the invasion, even without major disruptions of shipments. (This is what happened during Russia’s 2014 takeover of Crimea.)

Four major exporters—Ukraine, Russia, Kazakhstan, and Romania—ship grain from ports on the Black Sea, which could be disrupted by military action and sanctions. Any interruption to the flow of grain out of the Black Sea region is likely to have a major impact on prices and add further fuel to food inflation at a time when affordability is a major concern across the globe following the economic damage caused by the pandemic.

Metals

Also fueling inflation fears are possible shortages of essential metals such as palladium, aluminum, and nickel, creating another disruption to global supply chains already suffering from the pandemic, the trucker blockades on the U.S.-Canada border, and shortages of semiconductors.

The price of palladium, which is used in automotive exhaust systems, mobile phones and even dental fillings, has soared in recent weeks because of fears that Russia, the world’s largest exporter of the metal, could be cut off from global markets. The price of nickel, used to make steel and electric car batteries, has jumped.

Firms at Risk

Some firms could also feel the consequences from the Russian invasion, though for energy firms any blow to revenues or profits might be somewhat offset by a potential oil price jump.

Britain’s BP owns a 19.75% stake in the Moscow-based energy company Rosneft, which makes up a third of its production, and has a number of joint ventures with Russia’s largest oil producer.

Shell, meanwhile, holds a 27.5% stake in Russia’s first liquefied natural gas (LNG) plant, Sakhalin-2, accounting for a third of the country’s total LNG exports and has a number of joint ventures with the state-owned energy giant Gazprom.

The U.S. energy firm Exxon operates, through a subsidiary, the Sakhalin-1 oil and gas project, in which India’s state-run explorer Oil and Natural Gas Corp also holds a stake. Norway’s Equinor is also active in Russia.

In the financial sector, the risk is concentrated in Europe, according to calculations by JPMorgan.

Austria’s Raiffeisen Bank International derived 39% of its estimated net profit last year from its Russian subsidiary, while Hungary’s OTP and UniCredit got around 7% from theirs, and France’s Société Générale was seen as generating 6% of group net profits through its Rosbank retail operations. Dutch financial company ING also has a footprint in Russia, though that accounts for less than 1% of net profit, JPMorgan numbers showed.

Looking at loan exposure to Russia, the French and Austrian banks have the largest positions among Western lenders at $24.2 billion and $17.2 billion, respectively. They are followed by U.S. lenders at $16 billion, Japanese at $9.6 billion and Germans at $8.8 billion, according to data from the Switzerland-based Bank for International Settlements.

German wholesaler Metro AG has 93 Russian stores generating just under 10% of its sales and 17% of its core profit while Denmark’s Carlsberg owns Baltika, Russia’s largest brewer, with market share of almost 40%.

Safe Havens

Inflation at multi-decade highs and impending interest rate rises have made February 2022 a bad month for bond markets, with U.S. 10-year rates still hovering close to the key 2% level and German 10-year yields rising above 0% for the first time since 2019. The Russia invasion of Ukraine could change that.

A major risk event usually sees investors rushing back to bonds, which are generally seen as the safest assets. This time may not be different, even if the Russian invasion risks further fanning oil prices and, therefore, inflation. In foreign exchange markets, the euro/Swiss franc exchange rate is seen as the biggest indicator of geopolitical risk in the euro zone as the Swiss currency has long been viewed by investors a safe haven. Gold, also seen as a shelter in times of conflict or economic strife, is clinging to two-month peaks.

Conclusion

As became clear from the pandemic, minor interruptions in one region can generate major disruptions far away. Isolated shortages and price surges—whether of gas, wheat, aluminum, or nickel—can snowball in a world still struggling to recover from the pandemic.

There is high inflation, strained supply chains, and uncertainty about what central banks are going to do and how insistent price rises are. The additional stresses may be relatively small in isolation, but they are piling on economies that are still recovering from the economic body blows inflicted by the pandemic. What’s also clear is that political uncertainty and volatility weigh on economic activity. That means the invasion could have a dual effect — slowing economic activity and raising prices.

Economists have been warning that a “soft landing” (in which central banks guide the economy onto a sustainable path without causing a recession) might be difficult to achieve at a time when prices have taken off and monetary policies across much of Europe and North America may need to readjust substantially.

The magnitude of the potential economic hit is far from certain, and for now, central bank officials have signaled that they will remain on track to raise interest rates starting next month, a policy move that will make borrowing money more expensive and cool down the economy. Bowen Asset expects a 25-basis point move.

This article contains information from Reuters.

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