Market Updates

Russian Contagion, the Wrong Kind of Inflation, and European Equity Markets

March 4, 2022 – Written by James Baxter

As the dust settles, financial markets are repricing for a significant shift in the global economic and political outlook brought on by the Ukraine/Russia conflict

As the dust settles, financial markets are repricing for a significant shift in the global economic and political outlook brought on by the Ukraine/Russia conflict: 

  • Oil prices have now spiked and are up roughly 45% in a year 
  • The Russian stock market has been closed all week and Russian equity valuations, roughly $1trn at the end of 2021, have effectively been written down to zero as neither Russians nor anyone else can sell them 
  • The Russian Rouble has collapsed roughly 70% against the dollar. 

As we said last week, the direct fallout from Russia is not, in itself, such a big deal (the human aspect aside); the whole of the Russian stock market was worth less than one third of Apple Inc. However, the main development this week is that there is probably no obvious quick fix.  War is notoriously unpredictable, but markets are focusing on a protracted conflict as the most likely outcome. 

What businesses and markets suffer most as Russia sanctions bite and are sustained? 

European equity markets and European banks appear at the top of the list.  Banks exposed to Russia will have loan write-downs and will no doubt have found creative new ways to lose money in a Russian collapse. Close to home shares in Lloyds and Barclays are down 5% this morning and Spain’s Unicredit, considered one of the most exposed, is down almost 10%. These banks were recovering nicely post the 2020 Covid shock but their trading outlook for the next few quarters looks a lot gloomier.  More broadly the FTSE 100 having held up reasonably well as other markets started to fall in January and February has shed 6% in two days. We are back to 7,000 –  an index level I really thought we had finally left behind.  

The rise in energy costs was already a worry and it is now going to create the wrong kind of inflation. Inflation driven by supply problems rather than demand is generally not good for equities. Inflation which started with supply chain issues post Covid had been showing increasing signs around the world of being driven by demand, not supply issues. This oil spike is most definitely supply side driven. It is likely to be more transient rather than sustained compared to demand driven inflation and will be bad for economic growth and equities generally.  The squeeze on consumers and company costs is likely to be worse in Europe than the US and Asia and another European recession is now a possibility, something not even on the table two weeks ago.  

As mentioned last week, our investment committee sat on Monday and there has been strong debate all week on what, if anything, we should do. We did make some changes to portfolios to move more defensively, which Nick highlights below.  We will continue to keep a close watch as to whether we make any further moves.  

We are undoubtedly going to see lower portfolio values next week as today’s equity market falls on top of yesterday’s feed into fund prices.  Sadly, there is no sugar coating that.  However, for those like me who like to remain optimistic there is a silver lining.  

We hold a lot more bonds than most wealth managers. 

I have spoken to a number of wealth management firms and investors of late who had all but shunned the bond markets in 2021 as inflation loomed and equities powered ahead.   

As we highlighted in February, the higher yield bonds that we hold did not help much with portfolio values in the short term as drops in these bond prices were almost as steep as some equity markets. That will not be the case now. I spoke at length to our largest (by exposure and volume of assets) bond fund manager yesterday and he reported very attractive yields appearing in bonds which will start to underpin prices. Utmost PLC, as an example, whose bonds prices have fallen since the start of the year are now yielding almost 8% p.a. This is a UK life insurance company with no exposure to Russia and a deep balance sheet. Similarly, stress tests of those European banks show them to be very well capitalised going into this crisis and easily able to withstand write offs on strong balance sheets. The problems here looking forwards are for shareholders not bond holders. The 12 to 18 month outlook for bonds just got rosier and for equities more uncertain. This is why we held on to them.  

The bonds in our portfolios increase the reliable investment income earned thereby underpinning returns in the medium term and give us a cushion of lower volatility assets which we can use to provide cash if you need to make withdrawals.   

Equity markets will do as they will and we are watching our managers very closely. If they are not up to muster, we will replace them. But we do not have to sell any equity funds in this down-turn and as they fall relative to our bond funds, they naturally become smaller allocations in our multi asset portfolios.