NNIP: Russia's latest push in Ukraine - what now?

February 22, 2022

By Marco Willner, Head of Investment Strategy, and Marcin Adamczyk, Head of Emerging Market Debt

On 21 February, Russian President Vladimir Putin signed a decree recognizing the separatist Ukraine territories of Donetsk and Luhansk. Russian troops entered the two territories as “peacekeeping forces”. These actions represent an escalation of the Ukraine crisis and the end of the 2014 Minsk framework for peace in the southeast country’s southeast Donbas region. What might it mean for markets?

Three key questions arise following the most recent developments in Ukraine:

• Will Russia recognize the independence of the entire Donbas? Separatists hold only a third of the region. At the moment, it seems that the Russian government will wait before recognizing the two separatist territories completely.
• How will the Ukrainian army respond to the Russian troops in Donetsk and Luhansk? If the Russian troops remain within the territory already held by the separatists, any military confrontations may be limited. But if Russian troops were to enter the non-occupied parts of the two regions, a military escalation would be likely.
• What sanctions will the US and Europe impose? Currently on the table are sanctions against individuals in the Russian leadership as well as economic and financial sanctions, including a ban of Russian high-tech imports and the exclusion of Russia from the international financial system Swift. In the event of extended military confrontations between Russian and Ukrainian troops outside of the separatist-held part of the Donbas region, more sanctions are likely.

Given the dynamism of the situation, we frame the further developments in terms of three scenarios over the coming four weeks. The most likely case is a relatively moderate scenario in which the Russian troops stay in the separatist regions. In this base case scenario, the US and Europe would issue limited sanctions such as restrictions against the Russian individuals. Another realistic scenario is one of escalation. If Russian troops penetrate farther into non-separatist held parts of the Donbas region, the Ukrainian army will react decisively. The US would react with widespread sanctions, for example, economic sanctions and potentially the exclusion from the Swift system. In the tail-risk scenario, Russian would enter further territories, even including the capital Kiev. In this extreme case, sanctions would also affect the energy sector.

Until now, the market reactions to the conflict have been moderate and rational. Russian equities, where the risk of sanctions have been priced in, have been hit most severely. Russian credit default swaps and the ruble have been less affected so far. Outside the affected region, the market reactions have been mild. European equities have been weak this year (-7.7%) for multiple reasons, but less so than US equities (-8.7%). Similarly, the oil price has risen strongly on the back of strong demand and low inventories this year (+26%). It is hard to say how big the impact of the Ukrainian crisis is. Overall, the markets have reacted moderately to the crisis so far.

If Russian troops stay in the separatist regions, market reactions are likely to stay muted. If any risk scenario materializes, the initial reaction would be most likely sizable corrections of risky assets and a flight to safety. The energy and commodity sectors would be most impacted in these scenarios. A temporary escalation might create attractive entry opportunities later on. On the macroeconomic side, the escalation would likely lead to another inflation spike and potentially to weaker growth in Europe in the coming quarters. Central banks would face an even more challenging balancing act between fighting inflation and supporting the economy. This is the neither the time for investors to take on further risk nor to panic. The further course of this conflict is highly uncertain and warrants a close monitoring.

Emerging market debt: greatest risk is Russian incursions in Ukraine-controlled Donbas

We think that the most benign scenario at this stage would be if the Russian army does not go beyond the already occupied territories. Ukraine may choose not to fight back and eight years of de facto control by Russian proxies over this region will become official. This situation would create the option for continued diplomacy and allow for de-escalation without an actual military conflict. Ukraine could continue to function as an independent country and keep working closely with the West. We would expect any US and EU sanctions in this scenario to be mild.

A more pessimistic scenario includes Russia recognizing the full territorial claims of the Donetsk People’s Republic and the Luhansk People’s Republic, and the Russian army invading the Donbas areas now controlled by Ukraine, which would probably fight back. The conflict could extend beyond Donbas, and the Russian army could invade other Ukrainian cities. In this scenario, we would expect more severe sanctions against Russia, which would put more pressure on Russian bonds and currency. This would potentially trigger broader risk aversion, directly affecting Russian and Ukrainian assets and creating a contagion risk among other EM assets.      

Fixed income: flight to safety in Bunds, Treasuries

Assuming any conflict is limited to Ukraine’s eastern provinces, the most obvious market reaction is a flight to safety causing lower yields for German Bunds and maybe also for US Treasuries. This is in line with what we have seen in recent days.

Despite the added complication of inflationary pressures as a result of rising energy prices, we think that the ECB will become less hawkish than before. This will support lower yields and lead to steeper yield curves. For Eurozone country spreads, we think the risk-off tone of the markets will dominate. If, however, spread widening goes too far and too fast, we would expect the ECB to “jump in” and, most likely with QE instruments, support the weaker countries, most likely with QE instruments.

We currently shy away from large, outspoken investment positions as uncertainty is high. We would probably not react to an initial post-attack move by positioning for lower yields and wider spreads; we would be more likely to use the opportunities of lower interest rates and wider spreads to position for a reversal, as we do not believe that this conflict will derail current economic and markets developments sustainably.

European equities may face sell-off, could later move higher in the absence of further escalation

European equities tend to overreact to geopolitical tensions and are likely to sell off significantly in the event of a Russian incursion into Ukraine. Such a sell-off would be very aggressive and quick; if nothing further happens, equity markets in European and elsewhere would move higher and cyclical stocks would start outperforming again on the back of solid growth and rising rates.

Current leadership in equity markets is dominated by cyclical sectors, such as energy stocks, original equipment manufacturers and banks. A larger conflict would have enough longer-term impact on commodity prices to lead to an economic slowdown, which would shift leadership away from “cyclical growth” stocks and back to “secular growth” stocks.

The main transmission of tensions is via commodities, given Russia represents some 10% of global oil production and 40% of European gas. Russia is also a key player in nitrogen, palladium, nickel and potash. Commodity and energy companies will be seen as the place to hide and would benefit from price increases. In our main European equity strategies, we have overweight positions in energy and, to a lesser extent, materials, so we would foresee no major change.

Although Russia only accounts for very limited assets in the European banking sector, any escalation could trigger a flight to safety in German Bunds and US Treasuries. Lower markets overall would lead to a significant underperformance from the banking sector; we would need to reconsider our current inline or overweight position in banks.

Hans van Zwolle, senior portfolio manager LDI & rates, and Maarten Geerdink, head of European equities, contributed to this story.