With military tensions flaring on the border between Ukraine and Russia, investors are curious about what this all means for markets.
News out of the region over the weekend has not been encouraging, and it’s certainly not likely to be taken positively at the open on Monday by Russian stocks, bonds, and the ruble.
However, investors have largely already positioned for downside in Russia, for reasons unrelated to the latest headlines out of Ukraine.
Indeed, according to Bartosz Pawlowski, global head of emerging markets strategy at BNP Paribas, shorting the ruble has become one of the most popular trades since late January, when market participants realised seasonality effects — normally supportive of the ruble early in the year — were unlikely to give it much support in 2014.
“The ruble has been selling off for months now, regardless of the situation in Ukraine,” says Pawlowski.
“Granted, the events there have accelerated the process, but nothing more.”
Now, the Ukraine conflict has pushed the ruble further into territory that the Central Bank of Russia deems impactful on inflation, which it is trying to reduce.
“Below-potential economic growth, lagged effects of slower money supply growth in 2012-13 and smaller tariff hikes are the factors pushing inflation downwards,” says Eldar Vakhitov, an economist at Barclays.
“However, the intensifying ruble depreciation pressures may offset these trends: the CBR estimates the inflation pass-through effect at about 0.15 percentage points over one to two quarters. Given this, reaching the year-end 5% inflation target will be a serious challenge for the CBR.”
Russia’s year-over-year consumer price inflation rate currently stands at 6.1%, and given upward pressures from a falling ruble, BNP’s Pawlowski believes the central bank will choose to act.
“Unlike in recent months, the likely weakening of the ruble in the coming days will be met with a more forceful reaction from the Central Bank of Russia — I am expecting bigger interventions and possibly market rates spiking due to liquidity drainage,” he says.
Should Russia move further down the path of military intervention, markets will likely be in for sustained turmoil. However, many see this as a limited possibility, as Russia cannot really afford a war at the moment given the state of its economy, and blowback in the form of international economic sanctions could be extremely painful for the country.
“Direct costs of war to Russia could reach at least 3% of GDP, which consists of nearly half (or about $US30 billion) of gas exports from Russia to Europe, which is carried out through Ukraine and which would most likely be disrupted in case of a war,” says Vladimir Osakovskiy, an economist at BofA Merrill Lynch.
“On top of that, Ukraine itself is also a market for another $US30 billion of Russian exports to the country. Apart from economic, we would also not rule out major political costs from military action, as most of foreign Russian partners will most likely proceed with all forms of diplomatic and political pressure in response to the outright intervention.”
However, Osakovskiy also warns that the “tense concentration of armed forces from both sides can be easily destabilized by provocations from either side,” highlighting in particular “the prevalence of loosely controlled paramilitary forces on both sides of the conflict, which potential trigger such provocations.”
How might these events spill over into developed markets, like those in Europe?
“Monday should bring a lower Bund yield and EUR/USD at least to discount the ordinary risk scenario of another [gas] supply interruption,” say John Normand and Fabio Bassi, strategists at JPMorgan.
“But unless that interruption is sustained for many weeks, Ukraine does not look like a trend driver of govies, swap spreads or the currency. If the extraordinary event (military conflict) occurs, however, minimum targets should be about 10 basis points on the Bund, 3-5 basis points on 10-year swap spreads, and 3-5 cents on EUR/USD, so comparable to a moderate burst of market volatility.”
If war were to arise, developed markets would certainly be in for some volatility, but the pain would likely be felt most acutely in Eastern European markets. In a note to clients, BofA Merrill Lynch strategist Arko Sen walks through what that might look like:
In the tail scenario of the situation escalating further toward an outright conflict, we would expect contagion to EEMEA debt, FX and even broader markets to be fairly sharp. The impact, we think, will be largest on the following assets, albeit for varying reasons: Russia Eurobonds, CDS, and OFZs — which have lagged the weakness in the ruble significantly so far. The ruble, however, is already weak and could find more CBR support as distress mounts beyond economics … Poland’s geographical and political proximity, and Hungary’s proximity as well as exposure via OTP in Ukraine, would weigh on them along with Poland’s liquid status and relatively heavy positioning and Hungary’s heavy local issuance needs this year.
To the extent that the situation pushes up energy prices it could if this persists mount to a significant terms-of-trade shock for the likes of Turkey and South Africa in particular, placed as they still are just at the start of a much needed current account rebalancing. For now, we maintain our positive bias on South Africa external debt, but would look to turn more neutral if necessary. Early last week, we also closed our long South African rand position tactically.
Finally the relatively less liquid markets, like Romania local debt/FX and external debt in Georgia or Belarus, are likely to initially hold in, but risk sudden weakness if matters escalate.
In any case, it’s likely to be a long week for investors in the region.
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