The bears march on (in)

Global equities endured another down month as the MSCI All Country World Index, a broad measure of global equity markets, declined 2.6% during February. For the first time in a number of months, talk of inflation or interest rate hikes did not dominate headlines. Instead, the invasion of Ukraine by Russian forces has been the main talking point.

The bearish tone that gripped equity markets at the start of the year was underpinned by the growing prospect of interest rate hikes by major central banks, especially the US Federal Reserve. A different kind of bear, specifically a Russian bear has now moved into the vanguard. Concern over a Russian invasion into Ukraine had been bubbling under the surface for some time now but the “will he or won’t he” was finally answered when Russian president, Vladimir Putin, ordered his forces to enter neighbouring Ukraine. This is arguably the most significant act of war since World War II and has instilled additional fear and uncertainty into global financial markets. Unsurprisingly, European indices were some of the hardest hit as we saw sharp declines in the French CAC40 (-4.9%), the German DAX (-6.5%) and the Netherland-based AEX (-3.1%). The UK-based FTSE 100 bucked the downtrend ending the month slightly higher as it gained 0.3% following strong performances from various mining counters. Outside of Europe, US equities were unable to escape the pain with the S&P 500 and Nasdaq indices falling by 3.1% and 3.4% respectively. In Asia, Geo-political tensions weighed on equity markets though mainland Chinese equities still managed to end the month in positive territory as the CSI 300 Index, a broad measure of equities that trade on the Shanghai stock exchange, gained 0.4%. However, in Japan, equities followed many other global equity markets lower, falling 0.4%, and in Hong Kong the Hang Seng declined 4.6%.

The biggest fall was of course by the Russian RTS Index which lost over a third of its value bringing its year-to-date decline to more than 40%. Trading of shares on the Moscow Exchange has subsequently been suspended but shares of Russian companies trading on exchanges in other parts of the world have fallen heavily. The US, UK and Europe have reacted with stern sanctions against Russia. Sanctions levelled against certain individuals such as Vladimir Putin, his ministers, wealthy Russians and executives of Russian financial institutions include the freezing of foreign-held assets as well as travel bans into those regions. From a corporate perspective, exports of certain technologies, specifically semiconductors, has been restricted, Russian airline Aeroflot has been banned from much of Europe’s airspace and Russian defence companies have been placed on the sanctions list. The most severe sanctions have been levied against Russian banks in a bid to financially cripple the nation. Assets have been frozen and perhaps the harshest action has been to cut off a number of Russian banks from the SWIFT payments system.

SWIFT stands for the Society for Worldwide Interbank Financial Telecommunication. It is a platform or messaging service used across the world by financial institutions that enables the exchange of information on cross-border money transfers though money is not transferred across the platform itself. By blocking Russia’s access to the system, it will be incredibly difficult for companies to make and receive cross-border payments. The Russian economy is heavily reliant on the export of commodities such as oil and gas, various metals as well as wheat and the “swift action” will likely have dire consequences for Russian corporates and its citizens.

Prices for these commodities have risen sharply in anticipation of the impact of sanctions. It is estimated that between Russia and Ukraine they account for nearly a quarter of the world’s wheat supply.  As a result, the price of the grain has soared during the month along with the prices of palladium and rhodium, key components in catalytic convertors for internal combustion engines, as Russia is a major producer of both platinum group metals.

Perhaps the biggest area of concern for commodities lies with energy prices. Russia supplies Europe, especially Germany, with a large quota of natural gas for energy and heating purposes and while it may not produce as much oil as Saudi Arabia or the US, Russia is still a significant contributor to global oil production. Prior to Russia’s invasion, global oil supply was already chasing demand and the price of Brent crude had risen above $90 a barrel. As Russian tanks now roam the streets of Ukraine, the threat of supply disruption has driven the price above $100 a barrel and the possibility of the price moving even higher cannot be ruled out. 

Sanctions and the removal from the SWIFT system are likely to have a devastating effect on the Russian economy as well as its currency which has already begun to feel pain. The rouble has essentially turned into “rubble” having declined by more than a third against the US dollar and Russian bonds have halved in value. The Russian central bank has responded by increasing its main interest rate from 9.5% to 20%. Russian citizens have formed long queues outside Russian banks and ATMs as the bank run begins.

The fear that has permeated into markets has led many market participants to move into safe-haven assets such as gold as well as the US dollar. The yellow metal gained 6% during the month, closing above $1900 a troy ounce for the first time in over a year. In times of crisis, investors often turn to the world’s reserve currency, the US dollar, for protection. This was certainly the case during February as the world dollar index, a measure of US dollar performance against other major world currencies, showed that the greenback strengthened during the month. This was also evidenced by the decline in the US 10-year Treasury yield. Since the beginning of the year the benchmark rate had been trending higher in anticipation of interest rate hikes, rising from 1.3% to above the pre-pandemic level of 2.0%. However, demand for the safe-haven asset drove up its price and consequently drove down its yield (there is an inverse relationship between the price and the yield of a bond) as at it ended the month at 1.8%.

On the subject of longer-term interest rates, it is worth taking a step back to remind ourselves that while the Ukraine crisis will continue to garner headlines and create volatility in markets, especially those related to commodities, the impending interest rate hikes cannot be ignored or downplayed. Eurozone inflation hit a record high of 5.1% and in the US, the latest figure of 7.5% represents the highest level of inflation in four decades. Rapidly rising inflation in the US and Europe has prompted central banks to adopt a more hawkish stance and commence hiking interest rates in an effort to curb rising prices. The situation in Ukraine may negatively impact economic growth as well as drive inflation higher on the back of soaring commodity prices but a period of rate hiking will still be a key market driver, most likely the dominating factor. The conflict in Ukraine may influence the extent and duration of the hiking cycle but that will only become clearer over time.

On the home front, the commodity-heavy JSE All Share Index ended the month in positive territory gaining close to 3% as miners benefitted from higher commodity prices. There were strong double-digit gains across the board for mining counters, both diversified as well as precious metals. These gains more than offset the sharp falls in technology stocks such as Naspers and Prosus having sold off following the shift by market participants to lower-risk, safe-haven assets. Higher commodity prices also played a part in the latest National Budget which showed a healthy overshoot for government revenue tax collection, specifically from corporates that have benefitted from a commodity price boom. Assuming commodity prices remain healthy, a big assumption in of itself, they could go some way to reducing South Africa’s ballooning budget deficit. An additional positive to come out of the latest budget was the reduction of the corporate tax from 28% to 27%. A lingering concern that does remain is the projected growth of South Africa’s debt level relative to its gross domestic product which is still expected to breach 70% in the not-too-distant future. Coupled with structural challenges that would require some hard decisions in order to reform the status quo, forecast economic growth remains in the mediocre range of 1.5% to 2.0%.