One year on: the Russia-Ukraine conflict

It is now a year on from Russia’s invasion of Ukraine. Alongside the profound and terrifying humanitarian crisis it has precipitated, it has also brought significant disruption to the global economy and financial markets. However, investors should not attribute all the recent turbulence to the crisis; many of the problems were already in place and may continue even as the conflict stabilises.

The immediate effect of the war was to drive the price of commodities higher. This was felt particularly strongly in gas prices, with European wholesale gas prices rising as much as 15-fold over 2022 [1] as Russian supply was taken out of the market and sanctions took effect.

Global wheat prices increased over 60% from February to June 2022 [2]. Russia had been major exporters of metal, which then led the prices of nickel, palladium and aluminium to spike higher too. In some cases, these commodity prices have started to normalise, but remain elevated compared to pre-invasion levels.

While commodity-price inflation has contributed to mounting inflationary pressures over the past 12 months, it was not the sole cause:

• Pressures on the price of goods and services had already been building, as the reopening of economies after the pandemic renewed demand for goods and services
• Supply-chain problems remained in the wake of lockdowns, reducing the supply of key goods
• Finally, the large stimulus packages issued by central banks and governments also contributed

That said, even prior to the invasion, the Consumer Price Index (CPI) had already reached 5.5% in the UK, and 7.7% in the US [3]. With the impact of the war, inflationary pressures grew, ultimately peaking at 9.1% in the US and 11.1% in the UK [3].

There have been a number of consequences from rising inflation. The most obvious was an abrupt reversal in the low-interest rate policy that had supported markets since the global financial crisis of 2008-9. The US Federal Reserve and Bank of England both raised rates eight times in 2022 [4][5][6].

This had profound implications for the investment landscape. Higher interest rates raised the ‘risk free’ rate (the theoretical return on an investment with no risk), forcing a reappraisal of the high valuations seen in some parts of stock markets, notably high-growth technology and consumer discretionary stocks. ‘Value’ areas – and mining companies in particular – reversed their decade-long run of relative weakness.  Higher interest rates also raised bond yields – the UK 10-year gilt started the year with a yield of 1.2% [7], ending it with a yield of 3.7%.

This was a painful period in financial markets. Bonds and many major equity markets saw double-digit falls [8]. The only resilient spots were in areas that many investors had moved away from on ESG grounds – fossil fuel companies, mining, tobacco – plus commodity-heavy emerging markets such as Brazil. Equally, many investors were wrong-footed by the lack of ‘safe havens’ – holding bonds alongside equities did not provide any portfolio protection, a rare occurrence, with ‘defensive’ government bonds seeing double-digit falls.

Rising rates and inflation exerted a drag on growth, having started the year predicting that global growth would hit 4.4% in 2022 [9], by October, the International Monetary Funds’ (IMF) forecast had dropped to 3.2% [10], saying; “The cost-of-living crisis, tightening financial conditions in most regions, Russia’s invasion of Ukraine, and the lingering Covid-19 pandemic all weighed heavily on the outlook.”

As the IMF makes clear, not all of the current economic weakness can be laid at the door of the Ukraine crisis. Undoubtedly, it contributed to existing inflationary pressures, but many of those pressures were there anyway. Equally, as commodity prices have dropped, it is clear there are still other inflationary pressures in the system.

So far companies have benefitted from the inflationary pressures and many businesses have been able to pass on the rise in costs to consumers which has supported earnings growth.  However, the 2023 landscape is looking challenging for businesses, with input costs rising; wage demands intensifying as workers seek to ensure their pay packets meet the growing costs of living; increasing borrowing costs, with the era of easy money firmly at an end.

However, this environment does favour certain types of companies: those with low debt, strong pricing power and strong market positions.

The longer-term consequence of Russia’s invasion could see an acceleration of the transition to renewable forms of power. European powers have scrambled to deal with the short-term crisis as best they can – finding alternative sources of energy such as Liquified Natural Gas, refiring coal plants, and accelerating nuclear energy programmes. For many countries, this is not simply a matter of hitting net-zero targets, but of national security.

It is worth noting that this process was happening anyway. In the UK, for example, 2020 marked the first year that the electricity supply came predominantly from renewable energy, with 43% of its power being generated from wind, solar, bioenergy and hydroelectric sources [11]. It took 47 years to generate half a trillion kilowatt hours (kWh) of renewable energy, and just six (2017 to 2023) to produce another half trillion [11].

However, the war has galvanised policymakers. Two major pieces of legislation were enacted over 2022, directing capital into green energy projects – the Inflation Reduction Act, and RePowerEU. Both seek to reduce dependence on unstable regimes for crucial energy supplies and build a more sustainable energy policy for the future.

The war in Ukraine is symptomatic of a more fractured world, with rising tensions between nations. The crisis has coincided with an increasingly difficult relationship between the US and China that has seen protectionist measures on both sides. The 2022 CHIP & Science Act from the US Government, for example, sought to exclude Chinese technology groups from key US technology infrastructure [12]. These geopolitical tensions could lead to more spending on defence and cyber security, as nations seek to protect themselves from threats.

Equally, it is also prompting a retreat from the globalisation trend that has been a feature of trade over the past three decades. Companies are increasingly bringing their supply chains closer to home, holding higher inventories. The vulnerability of complex cross-border supply chains, based on the cheapest source of supply, was exposed during the Covid pandemic. Companies are increasingly choosing security over cost. This has important implications for former manufacturing hubs, and for the companies themselves. It may raise costs, but could help support areas such as robotics, as companies look to save costs elsewhere.

The Ukraine crisis may not have fundamentally altered the course of inflation, financial markets or the global economy, but it has accelerated existing trends. These trends are long-term and significant. At Evelyn Partners, they form an important part of our analysis and asset allocation as we strive to future-proof our investment portfolios.

Sources:

[1]Zettelmeyer J., Tagliapietra S., Zachmann G., Heussaff C., Beating the European Enery Crisis, International Monetary Fund, imf.org, December 2022

[2]Statista research department, Change in average price of selected commodities from February 24 to June 1, 2022, Statista, statista.com, 20 December 2022

[3]Refinitiv/Evelyn Partners

[4]Tepper T., Federal Funds Rate History 1990 to 2023, Forbes, 1 Feb 2023

[5]Eurozone Interest Rate Decision, Investing.com, 2 February 2023

[6]UK Interest Rate Decision, Investing.com, 2 February 2023

[7]UK 10-Year Gilt, Marketwatch.com, [accessed 17 February 2023]

[8]Refinitiv/Evelyn Partners

[9]World Economic Outlook: Rising caseloads, a disrupted recovery, and higher inflation, International Monetary Fund, imf.org, January 2022

[10]World Economic Outlook: Countering the cost-of-living crisis, International Monetary Fund, imf.org, October 2022

[11]How much of the UK’s energy is renewable?, National Grid, nationalgrid.com [accessed 17 Feb 2022]

[12]The CHIPS and Science Act: Here’s what’s in it, Mckinsey & Company, mckinsey.com, 4 October 2022