War in the Ukraine, Global Economic Consequences

The Russian invasion of Ukraine overturned a lot of expectations on the near-term direction of the global economy. The destructive military action and its subsequent economic and financial ripple effects have become the chief driver of the market’s swift, volatile moves (both downside and upside) since the end of February 2022. This volatility has spiked across virtually every asset class, with ruptures in the commodity space sparking the latest discomfort.

Russia’s Debts and Default

Until the Ukraine invasion, Russia had been considered one of the world’s safest bets for sovereign debt investment, due to the country’s low GDP-to-debt ratio and its sizable foreign reserves. Default could have devastating economic ripple effects.

Sanctions imposed by the U.S. and Europe on Russia’s central bank have frozen access to a large portion of its foreign exchange reserves. Fitch Ratings has downgraded Russia’s credit to “C” (junk status) and Moody’s and S&P Global, the two other dominant international credit agencies, made similar moves.

But Putin’s regime has so far defied expectations of imminent default, continuing to make debt payments and replenish some of its reserves using money from energy exports. Still, sanctions on Russian oil and gas exports have limited this major revenue stream for the country and strained its cash flow. So, Russia remains at risk of defaulting on its debts as sanctions choke off its access to dollars and other global currencies to pay lenders.

Global banks are most vulnerable to a potential Russian default. Russia has 15 international bonds outstanding that are denominated in dollars and euros with a face value of around $40 billion. Prior to the invasion of Ukraine, roughly $20 billion of these bonds was held by investment funds and money managers outside Russia. Bonds issued by Russian firms are in a popular JPMorgan Chase emerging-market corporate bond index known as the CEMBI. The bank said on March 7 that it would exclude Russian sovereign and corporate debt from its indexes, effective at the end of the month.

While Russia has not formally defaulted on its $38 billion of ruble-denominated sovereign debt, its central bank has already banned coupon payments to foreign owners of the ruble-backed bonds known as OFZs (for Obligatsyi Federal’novo Zaima, translated as “Federal Loan Obligations”). This ban can be considered as technical default.

The Russian move came in response to the denial of access to most of its $630 billion foreign reserves held with the U.S. and its allies, which can also be deemed as technical default. In February 2022, the Dutch financial services firm ING reported that the share of OFZs held by non-Russians had dropped to about 18%.

In mid-March, Russia owed just over $117 million of interest payments on two bonds, with a 30-day grace period typical of most international bonds. Russia did pay the interest due and avoided default, easing doubts about its willingness and ability to honor external debt after the sanctions were imposed.

On March 31, Russia made a $447 million coupon payment in dollars for debt due in 2030. JPMorgan Chase, which is Russia’s foreign correspondent bank, processed the payment after checking with U.S. authorities, according to Markets Insider. Russia’s Finance Ministry said it also made a $102 million Eurobond payment due on March 28. According to the Eurobond prospectus, “if, for reasons beyond its control, the Russian Federation is unable to make payments … in U.S. dollars,” settlement may be made in euros, pound sterling, Swiss francs, or rubles.

Russia’s biggest payment of the year—and its first full repayment of principal, amounting to $2 billion to be paid in U.S. dollars—was due on April 4. But after the Russia’s Finance Ministry filed notifications for an “interest payment” and “principal repayment,” the country was able to buy back about three-quarters of the debt in exchange for rubles, an unusual move that shrank its dollar obligations.

That still left $552 million to be paid. But on April 4, according to the New York Times, the U.S. started blocking Russia from making debt payments using dollars held in American banks, a move designed to deplete its international currency reserves and potentially result in a default. In this case JPMorgan Chase was prevented from processing payments by the Treasury Department said that restriction is meant to force Russia to choose between draining its remaining dollar reserves, using new revenue from energy payments to make bond payments, or default. The Treasury’s April 4 action blocked the $552 million payment, but Russia has a 30-day grace period to complete the transaction before it might be found to be in default. An $84 million coupon payment was also due on April 4 on a 2042 sovereign dollar bond.

While the successful payments made by Russia so far may give investors’ confidence, a bigger unknown is approaching at the end of May when an exemption on international debt payments by Russia comes to an end.

The current exemption, which allows U.S.-based entities and investors to receive Russian debt payments, is set to expire on May 25 unless extended by the Office of Foreign Assets Control, the body that oversees the sanctions. Under the license granted by the agency, Russia is able to make payments to international investors up until May 25.  On May 27, about $100 million in interest payments are due.

The United Kingdom has also announced its own set of exemptions for financial institutions to facilitate bond-payment flows. These will last until June 30, unless extended.

Without new extensions, Russia could be left unable to pay its creditors even if it had the funds available. If Russia fails to make any of its bond payments within their defined grace periods or pays in rubles where dollars or euros are specified, it will be a historic default—the country’s creditors could try to force Russia to pay.

Russian sovereign bonds have cross-default provisions, meaning that once it is deemed in default on one bond issue, it can be deemed in default on all its outstanding sovereign obligations. Court challenges to get Russia to pay would likely take place in the United Kingdom, where many of the bonds were issued.

A default would lock Russia out of the international borrowing markets until the sanctions were lifted and creditors repaid for any losses they had suffered. It would also depress its credit ratings for some time, pushing up the interest rates the government and big Russian companies can borrow at.

Notably, bonds sold after sanctions on Russia over its 2014 annexation of Crimea contain a provision for alternative currency payments in dollars, euros, British pounds, or Swiss francs, with the ruble listed as an alternative currency option for bonds issued since 2018.

Russian corporates have nearly $100 billion of hard-currency bonds outstanding and are due to make around $17 billion of payments this year on that debt, according to data from JPMorgan Chase. International investors hold about $21 billion of Russian corporate bonds, or 22% of the total stock, a March 2 report by the bank said. More than 50% of the outstanding corporate bonds were issued by quasi-sovereigns or state-run firms, with a heavy skew toward oil and gas companies. The hurdles faced by these firms show how the punishing sanctions are having broad impact, as cautious banks try to avoid violating the rules.

Effect on Global Supply Chains

The invasion of Ukraine and its effects on transportation links exacerbate the supply chain disruptions which reached new heights during the COVID-19 pandemic. Russia, the U.S., and its NATO allies have already banned each other’s flights over their respective air space. These bans are likely to be extended to land and marine transportation. The territories affected cover a vast area of global transportation, further stressing the already-fragile global supply chain.

Transport companies, maritime insurance executives, and industry analysts say the situation in Ukraine, combined with uncertainty fueled by the sanctions, is causing backups of ships at some ports and could lead to longer delays in shipments. The cost of transporting cargo delivered by sea, land, and air, which had already jumped during the pandemic, is also under pressure as global oil prices surge. Any changes of routes for air or cargo shipping could also add to fuel costs.

Many of the containers stacked on docks undergo time-consuming customs inspections to make sure they are not carrying blacklisted items, such as spare airplane parts or semiconductors. The pile-up is not disastrous, but to prevent further congestion, some port operators are refusing to accept ships carrying any Russia-bound cargo.

Effect on Commodities

The nickel market, like much of the commodity world, has been upended by Russia’s war in Ukraine. Russia is a major supplier of nickel, which was already in short supply due to demand for electric-vehicle batteries and other industrial uses, such as stainless steel. Electric cars use lithium-ion batteries which are mostly made up of nickel. Since the invasion, the price of nickel has gone up 250%. The eight-day nickel-trading freeze is one of the highest-profile examples of how the war and the sanctions have reverberated through financial markets.

Equally important, Ukraine supplies about 50% of the world’s neon gas, which is used to produce semiconductor chips. Governments and large corporations are now scrambling to obtain alternative supplies, but the supply is tightening, and prices have dramatically increased. Both Russia and Ukraine are big exporters of grains such as corn, barley, and wheat, as well as fertilizer. While the war’s full impact on global food supplies is not yet clear, prices are already skyrocketing.

The Russian invasion of Ukraine is driving up global wheat prices as the conflict curbs exports of the crop. Russia and Ukraine grow about 14% of the world’s wheat and account for about 28% of global wheat exports. This perfect storm has seen the global price for wheat reach a 14-year high in recent days at a time when the economic fallout of the pandemic has already stretched household budgets. It has also put at risk food security in low-income food-importing nations such as Egypt, which buys 70 percent of its imported wheat from Russia and Ukraine, and Lebanon, which gets 80 percent of its wheat from Ukraine.

If wheat prices are driven significantly higher, does it mean the price of bread on a supermarket shelf in the United States will increase? Not as much as most might think, because on average the farmer’s share is about 6 cents (or 6%) for every dollar spent by a U.S. consumer on a loaf of bread. So even a 20% rise in wheat prices would only increase the price of a $4 bread loaf by about 5 cents.

There is, however, another important economic consequence of the invasion: the surge in energy prices. If these surges persist, much higher oil and natural gas prices will increase the costs of shipping wheat to mills, flour to bakers, and bread and cakes to supermarket shelves. Processing costs for all food and drink products, from baby food to bourbon, will also increase.

Higher natural gas prices will also ensure that nitrogen fertilizer prices remain at their current atypically high levels, or even increase further. This will most likely cause farmers around the globe to use less, with adverse impacts on crop yields.

Increase in Inflation Possible

Before the invasion, economists and policy makers had been hoping for a peak in year-over-year inflation this spring as supply chains healed from pandemic-related disruptions and the Federal Reserve begins an expected series of interest rate increases next week.

But the situation in Ukraine increases the chance that the inflation peak will be higher, and a descent to lower levels will take longer. The invasion has supercharged prices for oil, wheat, and precious metals, threatening prolonged higher inflation. Economic disruptions could further stoke inflation, in part because Russia is a top global supplier of oil and natural gas. The risk is for more uncertainty and continued high inflation for an extended period.

The spike in energy prices has put a damper on growth. Higher energy prices are a material, global shock. Europe is the most exposed. The U.S. is in a better spot, in our view, with a larger growth cushion thanks to the strong restart’s momentum—even if some of European weakness is bound to spill over.

What Does It Mean?

We’re in a different world, where the global economic outlook is much weaker. High energy costs will likely act as a tax on consumers and reduce business investment longer term. Moreover, financial conditions are tightening on the back of a stronger dollar and widening credit spreads as investors become more risk averse. Tighter financial conditions often precede slower growth.

With that backdrop, the Fed is in a tough spot. If it fails to follow through on tightening, it could lose its inflation-fighting credibility. On the other hand, if it tightens policy too much too fast it could push the economy into a recession. Moreover, it will be tightening policy during a period of turmoil in global markets that will likely lead to lower growth and reduced liquidity.

After the Fed’s mid-March meeting, they raised their benchmark federal-funds rate by a quarter percentage point to a range between 0.25% and 0.5%, the first-rate increase since 2018. They also penciled in six more increases by year-end. Officials signaled they expect to lift the rate to nearly 2.5% by early 2023—slightly higher than the level that prevailed before the pandemic hit the U.S. economy two years ago, when they slashed rates to near zero. Their median projections show the rate rising to around 2.75% by the end of 2023, which would be the highest since 2008. Fed chair Jerome Powell said that the agency could finalize a plan to shrink its $9 trillion asset portfolio at its next meeting, May 3 and 4, and to implement it shortly afterward. This is another form of quantitative tightening.

The Federal Open Market Committee (FOMC) statement attributed the need for rate hikes to the strength of the economy and the very tight labor market, which is pushing up wages and inflation.

The key message from the Fed is that it is focused on fighting inflation and is prepared to hike short-term interest rates steadily and reduce its balance sheet until it reaches its goals. We have no reason to doubt the Fed’s intentions but see a risk that it may be over-correcting after having missed the inflation surge since late last year. Investors should be prepared for a bumpy ride.

In Europe, the economic disruptions are likely to be even more pronounced, particularly in the Energy sector. There, look for the European Central Bank to be generally accommodative but for market volatility to remain elevated until a resolution is attainable.

Stocks have had two back-to-back downturns this year, followed by a relief rally. Leadership has flip-flopped, as has investor sentiment. Fed tightening and the war in Ukraine have been the dominant macro forces. The correction earlier this year was largely about higher inflation and rate hikes. Trying to trade around these short-term swings has been difficult, and we recommend a relatively neutral stance—while using the diversification associated with strategic allocations, and periodic rebalancing to navigate the volatility.

If you like reading our “Bowen Reports Blogs”, Bowen Asset does have a Facebook page: https://www.facebook.com/BowenAsset Please check it out as we frequently make comments on the page about not just finance and economic events that happen in between our blogs.