The financial markets in war times

• Markets fell sharply when Russia invaded Ukraine early on Thursday morning
• The conflict could aggravate and prolong energy market disruption
• Central banks might end up trying to alleviate the impact on growth by backtracking on previous plans and delaying or softening rate hikes

Markets were already under pressure in recent weeks as Russian troops amassed on Ukraine’s eastern border and they fell sharply when Russia invaded Ukraine early on Thursday morning. 

Global indices plunged and even bonds offered no real haven: yields failed to collapse due to uncertainty over central bank policy. Gas, oil and wheat prices surged. Crude Brent hit $105 intraday on Thursday and the euro tanked to 1.11 against the US dollar.

Given persistent inflation and now sanctions against Russia, central banks might end up trying to alleviate the impact on growth by backtracking on previous plans and delaying or softening rate hikes. The ECB will be scrutinising the situation for any damaging signs. The Fed is keeping a close eye on US consumers. February's PMI were up sharply, providing confirmation of a sharp rebound as the pandemic retreats. At the same time, there were signs that global supply chains were beginning to open up. The challenge for central banks is to gauge rate hikes so that they reduce inflation without jeopardising the recovery. Jerome Powell will appear before Congress on March 2 and 3 to report on the situation.

In Europe, equities with high Russian exposure plunged. Russia is a bigger trading partner for Europe than for the US. European banks have $90bn in Russian commitments compared to only $25bn for US banks. But the big problem will be energy as Europe depends on Russia for 45% of its coal, 40% of its gas and 23% of its oil. Many industries could see their added value fall if there were sudden supply cuts. Russia also produces the palladium used in catalytic converters and titanium for the aerospace industry. Any embargo on Russian production will mean paying up for replacements. 

The conflict could aggravate and prolong energy market disruption, and especially gas which has been under pressure for months. European consumers are already paying 30% more for energy as a whole than 12 months ago. Energy prices alone account for more than half of total inflation.

We are maintaining our neutral stance on our asset allocation. Geopolitical tensions are logically upstaging company fundamentals and central bank action. It is also not clear what Vladimir Putin's intentions are and whether Europe will be able to secure sufficient energy supplies.

EUROPEAN EQUITIES

Developments in Ukraine continued to dictate equity market moves. Trading was again highly volatile and indices ended the period firmly in negative territory, plunging after Russia invaded Ukraine early on Thursday morning. Oil prices popped above $100 and European gas prices rocketed to €130 per MWH. Wheat prices also surged as Russia is a big exporter. The big question now is whether Russia will be evicted from the SWIFT international payments system and if it will be forbidden from using the US dollar. 
On a more positive note, macroeconomic data was mainly better than expected. February's flash PMI index reflected a strong rebound in Europe, especially in services. INSEE’s business climate index told the same story. 

Danone reported excellent results that suggested the group was less affected by rising production costs than its rivals. However, its 5% exposure to Russia represents a strong brake on trading in today's troubled environment. PUMA sounded a little more pessimistic on the chance of supply side tensions easing. The group said its margins would be seriously hit throughout this year. Stellantis released record profits thanks to strong pricing power and in spite of lower volumes resulting from semiconductor shortages. Results at Eurofins Scientific (testing and support services) swept past expectations and management nudged guidance for 2022 higher. In consulting, Alten’s operating margin was significantly higher than the group's usual 10%. For 2022, management simply said like-for-like growth and operating margins would be satisfactory. Results at Covivio Hotels showed the business was recovering faster than expected even if European occupancy rates had still not returned to 2019 levels.

US EQUITIES

US indices plunged by 4% to 5% over the period up to Thursday evening following Russia’s attacks on Ukraine. All three indices are now in correction territory compared to recent all-time highs.

Initial US sanctions are targeting Russian banks and exports of tech products to Russia. Evicting Russia from the SWIFT international payments platform was not adopted after European countries failed to agree. And no measures were taken against Vladimir Putin’s personal assets or Russia’s energy sector. As a result, gas prices fell back by more than 20% on Friday morning. Joseph Biden said there would be further sanctions to come but that more US strategic oil reserves would be released. Brent crude then retreated to around $100.

Elsewhere, economic data reflected strong momentum. Growth for the second half of 2021 was revised up to 7%. The Chicago Fed’s business index rose to 0.69 in January, up from 0.07 in December and new weekly jobless claims fell 17,000 to 232,000. Only new housing starts retreated in January, down 4.5% but after a 12% rebound in December. Services PMI also recovered sharply in February to 56.7, or much better than the 53 estimated, and house prices were up 18.6% over 12 months.

In Fed news, FOMC member Christopher Waller argued for a rate hike in March and a 50bp move if necessary. He also said he was in favour of shrinking the Fed’s balance sheet from as early as July.

There was little company newsflow due to the Ukraine crisis and the fact that the earnings season was coming to an end.

JAPANESE EQUITIES

The NIKKEI 225 and TOPIX tumbled by 4.63% and 3.81% over the period, in tandem with a global sell-off throughout the week as the Ukraine crisis intensified. 

Mining and Electric Power & Gas rose 4.65% and 0.49% on expectations of further rises in natural resource prices caused by sanctions on Russia. Elsewhere, sectors like Rubber & Products and Air Transportation plunged 9.96% and 9.09%. 

Sumitomo Metal Mining rose 5.95% after raising its dividend for FY 2021. Bandai Namco Holdings gained 4.02% on new game releases. On the other hand, Bridgestone Corp., up sharply in the previous week after better than expected operating profits, plummeted 11.04% on profit taking due to the Ukraine crisis. Asahi Group Holdings also fell 9.27% after previous strength. 

On February 18, the government decided to extend its COVID-19 pre-emergency status for 17 prefectures until March 6, while allowing five prefectures to withdraw measures. The five prefectures that will exit the pre-emergency stage are Yamagata, Shimane, Yamaguchi, Oita and Okinawa. This is the first time measures have been lifted since the omicron variant triggered a sixth wave.

EMERGING MARKET

The MSCI EM Index was down 6.2% as of Thursday’s close. Markets plunged into risk-off mode amid military tension in Ukraine. The MSCI Russia crashed by almost 47% and the ruble hit a record low. The MSCI China was down 6%, while India retreated 7.2% in USD. Brazil outperformed other regions by only slipping 1.3%.

Russian forces attacked cities across Ukraine after Putin ordered an operation aimed at demilitarising the country. Initial G7 economic sanctions avoided excluding Russian banks from SWIFT and a detrimental impact on energy supplies to European countries. China pledged to maintain normal trade with both Russia and Ukraine while opposing sanctions and reiterating that Ukraine was a sovereign state.

China’s property market continued to see policy support as multiple banks in first/second-tier cities cut mortgage rates, accelerating mortgage approvals and lower down-payment ratios to support property sales. The housing department minister said China would build 2.4 million affordable houses. The NDRC and other departments jointly published a document approving construction of national computing power hubs in 8 eastern cities and the development of 10 national IDC clusters. The politburo called for stronger macro policies to support the economy in 2022. Alibaba’s fourth-quarter results were in line with estimates. The weak macro situation continued to drag but new investment losses narrowed. Management plans to focus on premium consumers, high-growth cloud and international commerce businesses. NetEase reported solid fourth-quarter earnings growth thanks to high-margin PC games. Haidilao announced a fourth-quarter profit alert with net profit missing expectations on more permanent store closures, labour costs and overseas losses. Table turn is expected to be multiplied by four in the second half. Hong Kong is to spend $21bn on supporting the economy as the city battles with a new Covid wave.

India’s finance minister is considering reducing tax on fuel prices further as oil prices continue to rise. In an effort to bolster its balance sheet, Vodafone Idea has been reducing its stake in Indus Tower. Indigo’s co-founder resigned from the board and sent the stock plunging after he said he was planning to reduce his stake in the company.

In Brazil, February IPCA-15 inflation came in at 10.76% YoY, or higher than expected and higher than January on a surge in durable goods and food inflation. Meli reported solid results, in line with expectations with revenues jumping more than 60% YoY. Although the NPL ratio improved, the gross margin remained under pressure. Localiza’s fourth-quarter results missed expectations on lower used car sales.

CORPORATE DEBT

CREDIT

Geopolitical tensions climaxed after Russia invaded the Donbas region in Ukraine. The news triggered a flight to quality, hitting risk assets but causing bond yields to edge lower. Profit taking logically focused on high-yield bonds, down 145bp between Monday and Thursday. Investment grade credit ended the period 82bp lower. High yield credit spreads logically widened by 24bp as investors hedged the iTraxx Crossover (370bp on Thursday).

Financial and hybrid debt was also hit by Russia's invasion. New issuance went into standby mode as credit premiums rose. Euro CoCos traded around a 560bp spread and hybrid corporates at 255bp. Legacy Tier 1 bonds continued to underperform following DNB’s decision not to call an issue. Financial and hybrid debt is now down 4% and 5%, respectively, year to date.

Unsurprisingly, given today's geopolitical situation, emerging country bonds were the hardest hit with premiums on the JP EMBI moving to 400bp. For example, Ukraine’s 10-year bond is now trading at less than 40% of par, down from more than 80% in the middle of this month. Russian bonds also lost at least 40 points. Sovereign emerging debt, as measured by the JP EMBI, is down close to 9% so far this year. The index lost 5% over the past week alone.

New high yield issuance remained closed for business but there were more upbeat earnings reports. Spain’s Obrascón Huarte Lain (construction) beat expectations, showcasing strength a little more than a year after its restructuring. 2021 EBITDA came in €91.2m and the order book surged to €3.7bn, or more than the initial €3bn target. Despite persistent auto component shortages, Faurecia's sales rose 8.1% over a year to €15.6bn and net losses were reduced to €79m from €379m in 2020. The main challenge now is to integrate Hella. In retail, Casino Guichard continued to suffer from a difficult market. The group lost €530m last year. In addition, net leverage rose 26.4% over a year to €5.86bn after Covid slowed its asset disposal programme.

CONVERTIBLES

The geopolitical mood soured gradually over the week before culminating with Russia’s military offensive against Ukraine. Once again, convertibles proved their ability to cushion falls on their underlying equities. Between Monday and Thursday, global convertibles, as measured by the ICE BofA Global 300 index, only dipped 0.8%, reducing the corresponding equity market fall by 69%.

The energy crisis was reinforced by news from EDF that 12 nuclear reactors out of 56 pressurised water reactors were now idle due to corrosion problems. But the energy crisis was a boon for some. LNG producer Cheniere Energy in the US reported a record $15.19bn in 2021 sales and upped its earnings guidance for this year by 19%.

French fintech Worldline is finally seeing light at the end of tunnel after a chaotic year on the stock market. After 18 months of searching, the group found a buyer for its payment terminals division. Private equity giant Apollo is to fork out €2.3bn. The deal will force Worldline to book a €900m write-off to reflect the difference in the price it paid Ingenico. Thanks to economies reopening, Worldline also reported a jump in sales to €3.69bn, up from €2.75bn in 2020.

GLOSSARY

• Investment Grade: bonds rated as high quality by rating agencies.
• High Yield: corporate bonds with a higher default risk than investment grade bonds but which pay out higher coupons.
• Senior debt benefits from specific guarantees. Its repayment takes priority over other debts, known as subordinated debt.
• Debt is considered to be subordinated when its redemption depends on the earlier payment of other creditors. To offset the higher risk, subordinated Senior debt has priority over other debt instruments.
• Tier 2 / Tier 3 : subordinated debt segment.
• Duration: the average life of a bond discounted for all interest and capital flows.
• The spread is the difference between the actuarial rate of return on a bond and the rate of return on a risk-free loan with the same maturity.
• The so-called "Value" stocks are considered to be undervalued.
• Markit publishes the Main iTraxx index (125 leading European stocks), the HiVol (30 highly volatile stocks), and the Xover (CrossOver, 40 liquid and speculative stocks), as well as indices for Asia and the Pacific.
• EBITDA: Earnings before Interest, Taxes, Depreciation, and Amortization.
• Quantitative easing describes unorthodox monetary policy from a central bank in exceptional economic conditions.
• Stress Test: a process which simulates extreme but possible economic and financial conditions so as to assess any impact on banks and measure their resilience to these events.
• The PMI, for "Purchasing Manager's Index", is an indicator of the economic state of a sector.

DISCLAIMER

25/02/2022
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