by Franklin J. Parker, CFA | for ongoing updates, follow me on Twitter.
The Summary
- The dominant news of the week is Russia’s invasion of Ukraine. In response, Europe and the United States have taken a series of steps, one of which was unexpected and unprecedented:
- Many of Russia’s major banks have been removed from the SWIFT international banking system.
- Many of these banks have had their ability to transact with foreign banks severed.
- Russian individuals have had their assets and property held in western allied countries frozen and/or seized, and their ability to move cash internationally severely curtailed (this includes Putin himself).
- Western allied countries have also sanctioned the Russian central bank—an unprecedented action. This means that some, if not all, of the $630 billion held in foreign reserves by the central bank is now inaccessible to the Russian government. I detail more of this action below.
- To date, natural gas flows into Europe from Russia have not been curtailed (oil and gas payments have been excluded from the otherwise expansive sanctions). Despite all odds, Ukraine has so far prevented the Russian military from accomplishing any of its objectives—no major cities have fallen, Russia does not have air superiority, and the leadership of Ukraine is not only intact, but they have become an international inspiration. In response to this frustration, and the crippling economic fallout, Russian leadership has opened talks with the Ukrainian government, and increased the readiness of their nuclear arsenal. Clearly the second point is disconcerting. Despite these developments, US investors appear to be mostly shrugging off the uncertainty.
- In addition to developments from Eastern Europe, investors will be watching PMI and jobs data very closely. January jobs figures post on Friday. A key input to Federal Reserve actions, this will be a critical data point leading into the upcoming FOMC meeting. At the upcoming Fed meeting, officials are expected to announce the completion of quantitative easing and a rate hike. Both a 0.25% hike and a 0.50% hike are on the table (my view is that 0.25% is most likely).
- In my view, the Fed has not been entirely priced away from markets, that is still an ongoing process though it does appear to be coming to an end. The price-to-earnings ratio based on this year’s expected earnings for the S&P 500 is 18.5—down considerably from its 21.5 of just a couple months ago (a contraction in valuation of 14%). My view is that multiples have just a bit more to contract, but we are quickly approaching what I see as a buying zone. Remember, once valuations return to more normal levels, earnings growth (which is quite strong) will begin to push prices higher. Of course, inflation and a broader conflict in Europe are very real risks to this view.
The Details
Over the weekend western-allied monetary authorities took the unprecedented step of sanctioning the Russian central bank. It is easy to gloss over these words (“sanctions” don’t seem to mean much these days), but this is an action with serious teeth. Let’s break down why.
First, the Russian central bank holds some $630 billion in assets, mainly the currencies of other countries. In normal times, this would allow it to stabilize major currency moves. If the ruble began to show considerable weakness, for example, the central bank could sell dollars and buy the ruble and offer some support. By preventing the central bank from trading in international markets, this tool is removed.
Second, the central bank can tap these reserves to offer some liquidity in currencies other their own. Many Russian companies, to access international capital markets, have borrowed in euros, dollars, and yen. With no ability to get euros or dollars or yen, these companies could, at worst, default on their obligations and, at best, see their borrowing costs skyrocket. The same goes for the government of Russia—without an ability to get foreign currencies, they are unable to repay their foreign-currency debts (which is one reason why Standard & Poor’s downgraded Russian debt to junk status, further pushing up their borrowing cost).
Third, any actions the central bank takes to stabilize their financial system must now be done by printing money rather than from existing assets—which can compound the inflation problem.
Fourth, and this is related to the sanctions more broadly, the inability of Russian companies and banks to interact with the global financial system creates massive frictions for manufacturing and services. Since almost everything manufactured today contains components manufactured in a foreign country, and since payments cannot be made internationally, this significantly curtails the ability of Russian companies to produce anything other than the most basic goods.
Of course, many of these problems can be overcome. China offers a window to the international financial system, for example. But fund flows and supply chains cannot be simply rewritten overnight. In the short term, the effects of these actions are likely to create massive price inflation, depression of asset prices, and a significant slowdown of economic activity.
Chart of the Week
The economic damage done to the Russian economy can be seen in the movement of their currency, the ruble. It hit it’s lowest-ever value relative to the US dollar, moving some 30% in a day. Currencies rarely move like this. To put this in perspective, when the results of the Brexit election posted, the British pound moved 12% over the course of a couple of days, and that was major news at the time.
Unfortunately, this adds to inflation pressures in Russia, which is a very high cost the average Russian will have to pay.
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