Geopolitical Issues Fracture The Investment Outlook

Whatever one may wish to term the current military conflict in Ukraine - a “special military operation to de-Nazify” the Ukrainian political system according to Russia, or “a devastating war on the sovereign state of Ukraine” according to that country – it is clear that this conflict has the potential to ignite a much wider and devastating global crisis.

As investors, we need to consider the implications and, in this respect, we see three major risks for financial markets:

1. Significantly higher inflation. The key here is further disruptions to the supply chain issues that arose from the Covid-19 pandemic, with an added overlay of prolonged higher prices for key raw materials and for energy prices.  The decision by the USA and many allies to either immediately ban Russian oil and gas imports, or at the least to accelerate a transition away from dependence on such supplies leads to the inevitability of higher prices in the short to medium term.

Further to this, Russia is also a key global supplier of fertilizer, and apart from the higher input costs from an energy perspective, there will be additional price pressures in the agricultural space.  We thus expect to see significant additional inflationary pressures and constraints in the global supply chain across multiple market sectors.

2. Global recession. We had previously flagged the overoptimistic growth assumptions embedded in many economic forecasts over the course of the next 12-18 months.  We had highlighted the potential for a more aggressive Federal Reserve, forced to act to curtail surging inflation, and the concomitant slowdown that could emerge from that monetary policy action.  We now see a more dovish approach from the Fed, as a result of the obvious slowdown that will come from the military conflict, but the Fed’s conundrum will be that inflation will almost certainly be higher than what they were expecting previously.  When all is weighed up, we believe the economy will be sacrosanct and they may well tolerate a higher inflation rate for a period of time.  Inevitably though, the longer the conflict and its economic effects remain, the higher and faster that rates will eventually have to rise in the future. 

Accordingly, despite the more dovish Fed, their approach will be unlikely to stave off some of the slowdown that comes from the natural braking effect that higher energy prices induces.  The risk is clear that the global economy could easily slip into a recession, and importantly it will be accompanied by stagflationary conditions. Inevitably then is that it will require another period of sustained countercyclical fiscal expansion to deflect the worst impacts. Fiscal concerns will again come to the fore for those countries who are already fiscally constrained, including South Africa.

3. Market dislocations. The threat of higher inflation and slowing growth will almost certainly lead to some sectors suffering more than others, and here we would highlight more cyclical areas eg auto industry, tourism, consumer cyclicals etc as being vulnerable. While we acknowledge that one positive from this particular crisis may well be an acceleration to transitioning towards more renewable energy sources, the lead times for such projects on such large scales will be too long for the short term energy needs.

We also wish to highlight that Russia’s exclusion from the global financial (and energy) system could be dangerous for European banks and financials who have funded recent Russian corporate expansion, and there is certainly a heightened risk of Russian credit defaults – both at corporate and sovereign level.  In this case, a prolonged risk-off appetite would likely pervade financial markets, likely leading to further losses across all assets not considered safe havens.

We cannot foresee how this conflict plays out over any term, and it would be impossible to attempt to forecast such outcomes. But there is one certainty that investors should acknowledge, which is that all risk scenarios are on the table, including a nuclear one, even though at this stage there appears to be only sabre-rattling on this issue.  In other words, there is a range of scenarios - a “good” scenario which sees the conflict being resolved sooner rather than later, all the way through to the extreme scenario of nuclear war.  Included within these scenarios would also be a non-nuclear one of extreme cyberwarfare causing the unthinkable event of the Internet going down.

Whilst South Africa has till now been somewhat of a beneficiary of recent higher commodity prices which has had the benefit of shielding the rand from excessive risk-off type moves, we do highlight that should global recessionary conditions emerge requiring further fiscal support from our already constrained fiscus, additional risk premium may need to be priced into SA bonds even at the current historically cheap levels.  In this scenario, the SARB is likely to be more cautious with raising the repo rate than what was previously expected, and as it is, our economy in any case can ill afford significantly higher interest rates, especially given the backdrop of our own energy constraints – read Eskom electricity supply.

Further to this we also note that in the extreme scenarios that could emerge - especially those involving more protracted military conflict, South Africa’s economy is ill-equipped to deal with a protracted period of global economic slump.  With that in mind as a possible outcome, we highlight the risk of social unrest, a little of which we saw in July 2021.  These potential outcomes would be devastating for the South African outlook.

Whilst we believe (and hope) that the current situation will be resolved sooner rather than later, and not necessarily in a positive manner, the reality is that we will see a protracted period of hardship at various levels, and we do not believe that all risks noted above are priced into markets and therefore investors should be cautious in rushing into believing an optimistic scenario lies ahead in the near term.