Market risk sentiment quickly unraveled yesterday, as investors reacted to what has been termed the biggest threat to European security this century. As Russian troops massed in Crimea, stocks in Moscow’s MICEX index crashed by around 9 per cent on the open (see graph), with the Russian central bank hiking rates by 1.5 per cent in an emergency measure to stem capital outflows. Safe haven assets spiked, with gold reaching a four-month high above $1,350 per troy ounce, and European equities fell sharply, with the FTSE 100 hitting a two-week low.
After a volatile start to 2014, including a mini emerging market crisis and the ongoing consequences of the US taper, there is a fear that any further escalation in Ukraine could complete a perfect storm for markets. And while financial contagion may not be everybody’s central forecast, analysts warn that extreme geopolitical instability is likely to prove an enduring market theme.
“As the situation in Ukraine worsens, we could see much larger moves in the markets,” says Nick Beecroft, chairman of Saxo Capital Markets. “Maybe this is even the catalyst for a major correction in stocks – we haven’t seen anything in the order of 10 per cent for a few years now.”
So far, the worst of the market fallout has been located in Russia and Ukraine, with both currencies and equities crashing – Russia’s rouble yesterday hit a four-year low against the dollar. But if Vladimir Putin orders troops to move beyond Crimea and into the east of mainland Ukraine, Capital Economics’s Andrew Kenningham says there is a risk this could accelerate the flight to safety in financial markets. “We don’t think this is the most likely scenario,” he says, “but any serious escalation of the crisis would likely see a further rush for high quality bonds, gold and the yen – all at the expense of equities.”
Perhaps just as worrying is the prospect of an interruption to the large amounts of Europe’s natural gas supplied by Russia. The likelihood of a deliberate cut-off is low, as it would not be in the interests of Russian gas companies (who sorely need the cash), or the European countries dependent on the supply. But it’s hard to rule out sabotage (accidental or otherwise) to one of the five pipelines flowing through Ukraine if conflict does materialise. The particular difficulty with a disruption to gas supplies, says Kenningham, is that, unlike oil, the extensive infrastructure and planning required means pipelines cannot easily be switched from one source to another. A long-term disruption to supplies would probably affect neighbouring countries like Bulgaria and Romania first, hitting their economies hard. In the most extreme scenario we could see blackouts in the region, he says.
But even if this disaster scenario is not realised, reverberations could be felt in emerging markets, especially Russia itself. In a note yesterday, Standard Bank’s Timothy Ash said that it is ridiculous to imagine that Moscow’s aggressive actions, and the associated prospect of international isolation, will have no negative effect on its economy.
“Russia is far from bankrupt,” says City Index’s Ashraf Laidi. But its current account surplus now stands at the lowest level since the fourth quarter of 1998, and international reserves have dipped to $498.9bn (£298.5bn) – their lowest in three years. This is taking place against the backdrop of falling growth rates. Last year, Russia’s economy grew by 1.3 per cent (compared to 3.4 per cent in 2012), and yesterday’s purchasing managers’ index (PMI) data from HSBC showed a fourth straight month of contraction for its manufacturing sector. Russian growth will also be hit by the emergency rate rise yesterday.
“If confidence continues to deteriorate,” says Kenningham, “and we see more capital flight, and further falls in the current account surplus, the risk of Russia’s balance of payments coming under pressure only rises.” Russian stocks could see further falls, while Laidi sees dollar-rouble as possibly heading towards 40 roubles, from its current level close to 36.5.
The real unknown quantity is how Western sanctions (the US State Department said yesterday that it is “moving down that path”) will accelerate these miserable dynamics. Ash argues that targeted sanctions on the elite could “make it very difficult for Russian banks and corporates to secure external financing or roll over debt liabilities.” The rouble’s downward trend could accelerate further, quickly eroding FX reserves, and pitching Russia into a vicious circle of ratings downgrades, corporate default, and lower long-term growth.
THE NEW GEOPOLITICAL REALITY
Russia’s belligerent behaviour can in part be explained by domestic economic problems, says Beecroft, with Putin seeking to distract from negative economic headlines. But Russia has also been emboldened by a calculation that any response from the West will be minimal. Laidi points out that there was no real reaction from the West when Russia occupied parts of Georgia, and that aggressive diplomacy from Nato could be the extent of any response in the case of Ukraine.
This could prove significant for markets. Whereas the US, with the support of a few key allies, was until recently willing to play the role of “global police”, the lack of action in response to the Syria conflict and now Ukraine points to a significant change, according to Dr Elizabeth Stephens of JLT. “The shift from a unipolar to a multipolar world creates new political risks.” It’s not as simple as the retreat of the US leading to a power vacuum, she says. But in a more decentralised world, regional powers like China, Turkey and Nigeria are less willing to take on the responsibility (and financial burden) of coordinating global leadership and responding to potential crises. This means that market-moving “Black Swan” events could become more frequent. If Stevens is right, geopolitics may come to disrupt markets to an even greater extent in coming years, meaning more volatility and shocks to energy prices over the long term.