“The near-worst case scenario is unfolding,” says Kunjal Gala, lead portfolio manager, Federated Hermes Emerging Market equities strategy. “But it is one of a number of scenarios we have been preparing for.”
Moscow’s exchange suspended trading for almost two-hours on Thursday morning (24 February) as Russian stocks plummeted. The Moex index fell 45% in early European trading, while the rouble tumbled to a record low against the dollar1.
The escalation in the conflict is set to have an impact on energy prices and Germany’s decision to suspend Nord Stream 22 will likely lead to elevated energy prices for a prolonged period, especially in Europe. European gas prices jumped more than 30%3 and Brent crude broke the $100 a barrel threshold on news of Russian airstrikes in Kiev4.
“The invasion creates uncertainty,” says Geir Lode, head of global equities at the international business of Federated Hermes. “But one beneficiary over the longer-term could be renewables companies with spending on green energy solutions likely to accelerate as Europe seeks to wean itself off Russian gas.”
The crisis is likely to have immediate and significant inflationary effects. Russia is a vital exporter of energy commodities and the main supplier of gas to Europe, while Ukraine is a producer of grains.
It is also world’s largest producer of palladium and a leading nickel producer, both of which are used in semiconductors. The escalating conflict could affect semiconductor supply chains, which was an issue through the pandemic, and have only just started to ease. “We may see further disruption to supply chains and could spill over into other sectors, such as autos,” says Lode.
Spreads on emerging market debt widened dramatically following the invasion. “Any stiff resistance from a fully mobilised Ukrainian army would prolong the conflict and would be one trigger for emerging market spreads to widen further,” says Mohammed Elmi, portfolio manager, Federated Hermes Emerging Market Debt strategy.
Further sanctions loom
Western governments are set to impose further punitive sanctions in response to Russia’s invasion. The European Union announced on Thursday morning that it will block Russia’s access to critical technology and other markets5.
“We expect further restrictions on the trading of secondary market Russian sovereign and quasi sovereign debt which complements the restrictions on primary debt issuance brought in over the past couple of days,” Elmi says.
“Far more significant would be sanctions specifically aimed at Russia’s energy complex; any measures aimed at either Gazprom, Rosneft will no doubt see a spike in energy prices, and force Russian energy consumers to source alternative supplies.”
Excluding Russia from the Swift international payments system would likely be the last resort, and would adversely affect western banks and investors, he added. “Looking further forward we would expect the initial risk-off mood to modulate – particularly given the ability for other emerging market commodity exporters to fill the gap created by sanctions.”
From a monetary policy perspective, the escalation in the conflict adds to the already tricky growth-inflation trade-offs central banks have been facing, making the upcoming decisions particularly hard.
The US Federal Reserve is widely expected to begin raising rates in a sustained fashion at its policy meeting on 15-16 March.
“In the current environment of already high inflation and concerns about second-round effects, central banks will likely continue to remove monetary stimulus. But downside growth risks from the geopolitical backdrop mean that they are likely to proceed gradually and cautiously,” says Silvia Dall’Angelo, senior economist at the international business of Federated Hermes.
The impact from the crisis on monetary policy will vary across different central banks. While the US Federal Reserve appears to be more insulated, the European Central Bank and the Bank of England face a more difficult situation, given that Europe is a net importer of energy commodities and relies on Russia for gas and, to a lesser extent, oil. “It’s fair to say that the crisis increases the room for central banks’ policy mistakes,” says Dall’Angelo.