Investment
25 February 2022

Investment Strategy: War in Ukraine – what's next?

By Jean Chia, Conrad Tan, Mansoor Mohi-uddin, Sim Moh Siong, Oleksiy Shkolnyk and Low Pei Han

Russia’s full-scale invasion of Ukraine in an attempt to depose the government has been swiftly followed by increased sanctions on Russia.

In this update, we address some of the key questions investors are asking about the latest developments and share our views on how to navigate the market turbulence ahead.

What are the key transmission mechanisms from the epicentre of the Russian invasion of Ukraine to global financial markets?

Inflationary pressure: If the scope of sanctions by the US and its allies extends to Russian energy sources, the supply shock on oil, gas and commodities will feed directly into rising input prices, and supply chain disruptions could prompt an upward spiral in consumer and producer prices. As this may be an untenable outcome for Europe and US, we put a low (<10%) probability on such a move.

On Thursday (24 February 2022), US President Joe Biden announced additional sanctions on Russia, including cutting off Russia’s largest financial institutions from the US, export restrictions on technological goods and stepping up restrictions for debt and equities issued by key Russian state-owned entities. Europe, UK and US allies including Japan and Australia have also announced similar sanctions in turn. But the Western allies stopped short of cutting Russia off from the global SWIFT payment system and blocking of energy exports – widely deemed to be the most extreme options in the arsenal of sanctions. NATO’s statement in response to the actions taken by Russia emphasised defence of the alliance, as well as the non-escalatory nature of its measures, including not sending in troops to Ukraine.

Risk of potential policy missteps and interest rate implications: Following the outbreak of war, central banks are likely to act cautiously when raising interest rates to curb inflation. Higher oil prices act as a stagflationary tax, increasing inflation but lowering consumers’ purchasing power. The latter is likely to slow growth in the near-term and thus reduce the need for central banks to increase interest rates aggressively by 50ps hikes rather than 25bps.

Geopolitical risk premium: A major concern among investors is that higher-for-longer energy prices could hurt global growth, leading to a de-rating of overall risk assets, particularly US and European equities. Prior to the invasion, US and European stocks had already been reeling due to decades-high inflation as economies recover from the pandemic. Markets have also been worried about tighter Fed policies with the escalating inflation.

For now, the US and its allies have significantly increased sanctions on Russia but continue to refrain from targeting energy supplies that would cause a greater shock to the global economy (see: Ukraine & Russia: War & Its Risks).

Russia accounts for less than 2% of European company sales, rising to about 5% if Central and Eastern Europe are included. Hence, absent a very material escalation in the Russia-Ukraine conflict, the risk to global equity prices is due to increases in risk premia rather than concerns about a fundamental hit to economic or profit growth, especially given that economic and earnings trends have been improving.

In Exhibit 1, we lay out the game plan for investors under three possible scenarios for what happens next.

	Macro/FX/Commodities	Rates/Fixed Income	Equities
Scenario 1: Tough but calibrated sanctions on Russia that leave its energy exports intact; ongoing resistance to the Russian invasion within Ukraine, supported by NATO.	Global economic recovery continues and major central banks stay on course to gradually tighten monetary policy. Oil shock avoided but spillover from high European gas could keep oil prices elevated in the near term. As oil prices ease below USD100/bbl by 2H22, stagflation worries should fade to the detriment of gold. Drag on the EUR will be brief and minor.	Credit spreads remain elevated while energy prices stay high in the near term. Cautious positioning in global fixed income with preference for Gulf Cooperation Council (GCC) investment grade credits and high-quality corporates.	Sell-offs to present opportunities for longer-term investors. Value/Cyclical sectors such as Financials, Energy and Industrials to outperform over longer term, supported by underlying economic and earnings growth and rising interest rate trajectory.
Scenario 2: Quick ceasefire and resumption of negotiations.	Global economic recovery continues and major central banks stay on course to gradually tighten monetary policy. Oil prices quickly ease back below USD100/bbl. Gold prices decline on the back of a resilient global economy and a hawkish Fed. Prospects of Fed tightening and the hawkish turn from the ECB point to both stronger USD and EUR against the JPY.	Market attention shifts away from the conflict and towards other macroeconomic concerns, namely inflation and rates. Buying opportunities in select global credit, as spreads have significantly widened in the space. African credit benefits as attractive diversification within CEEMEA, while Mexico and Colombia benefit from relatively high oil prices.	Equity markets to heave a sigh of relief from the alleviation of tensions, and investors’ focus will again return to underlying earnings recovery of companies and tightening of central bank policies. Maintain value/cyclical tilt as global economic recovery continues with the transition of the Covid-19 pandemic to endemic status.
Scenario 3: Protracted war and severe sanctions, including targeting of Russia’s energy exports; potential influx of war refugees into European Union.	Global growth slows, oil prices spike towards USD150/bbl and stay higher for much longer as sanctions disrupt Russian energy exports. Gold prices surge past USD2,000 to revisit historical high on escalating stagflation risk and prospects that Fed normalisation could be cut short. Conflict proximity and drag from high European gas prices could stall ECB exit from quantitative easing and weigh heavily on the EUR. Stronger USD and JPY on protracted risk aversion.	New sanctions impact energy exports from Russia, prolonged risk-off leads to further credit spread widening while US Treasuries rally (yields fall). Higher energy prices hurt global growth. Beneficial for safe-haven fixed income positioning in GCC investment grade credits as well as high-quality Chinese state-owned enterprises with energy exposure.	Though a spike in energy prices is supportive of the Energy sector, if this is sustained without a corresponding supply response from other energy producers, prolonged high energy prices would threaten economic growth and result in demand destruction, which is negative for cyclical sectors such as Consumer Discretionary.

Source: Bank of Singapore.

Looking at the risk-off episode when Russia invaded and subsequently reclaimed Crimea in February and March 2014, there was no lasting impact on risky assets. Although equities corrected briefly, all losses were quickly recovered. The 2003 Iraq invasion also showed similar patterns, with the S&P500 recovering quickly from the initial sell-off.

Across the past few decades, geopolitical risk events have only rarely been followed by a meaningful tightening in US financial conditions that are critical to global risk assets.

What can clients do? Investment Implications:Hedge for the worst: Risk management is an important part of managing downside risks including the tail risk event of a significant further escalation in sanctions and war casualties. Amidst any short-lived periods of calm, investors should purchase puts or put spreads on broad equity indices or stocks for downside protection.

Rebalance portfolios: In fixed income, bond investors should use the opportunity to rebalance portfolios towards more defensive segments such as Gulf Cooperation Council (GCC) investment grade credits and high-quality corporates.

In equities, we recommend that investors continue to take a balanced approach to be broadly diversified across regions, sectors and industries such as Financials, Energy, Industrials and selected Technology stocks. We currently prefer Asia ex-Japan from a regional equity allocation perspective, relative to the US, Europe and Japan.

Stay watchful for buying opportunities: Focus on fundamentals of sectors/countries that are more insulated from bear-case scenarios and that are well-positioned to tap longer term earnings drivers. Higher short term volatility could provide investors potential opportunities to sell puts and be positioned via structured notes to enter equity positions at lower entry levels.

Consider ESG and Alternative Investments as diversified sources of return: The crisis highlights the importance for sustainable energy sources across Europe and globally, validating the case for long term investment in sustainability-focused solutions. Amid volatility and high correlation in capital markets, the investment case for alternative assets such as private markets and real estate remains intact.

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