The Russian economy is likely to be severely impacted by the sanctions: on top of a possible confidence shock, the Central Bank of Russia has raised its key rate to 20% (from 9.5%) to slow down deposit withdrawals and counter the ruble (“RUB”) depreciation (the RUB has already depreciated by roughly 50% against the dollar since mid-February). The CBR has also decided to put in place some capital controls, notably temporarily banning foreigners from selling securities.

The war in Ukraine will impact world growth as commodity prices have surged (not only energy but also food and metals), but also because of renewed tensions on supply chains: Ukraine supplies more than 90 percent of U.S. semiconductor-grade neon while more than a third of palladium, a rare metal also used for semiconductors, is sourced from Russia. Some countries (in particular African and Middle East countries depending on Russia and Ukraine for wheat) are likely to be more severely impacted than others. But we continue to believe that the global recovery from the pandemic will not be fully derailed.

Our macro scenario for the Euro area

In Europe, risks on growth are skewed on the downside and we cannot rule out a “worst-case” scenario in which a full cut from Russian gas would trigger a recession. Still, for the time being, sanctions have been narrowly targeted in order not to directly affect Europe’s energy imports from Russia. Moreover, some offsetting fiscal measures have been decided to soften the blow – for example, Italy has already approved a €8 billion aid package for energy and auto sector relief, Germany has approved a €13 billion package to help households cope with surging energy prices, France has put temporary caps on regulated energy price hikes since late 2021. If tensions on the energy market do not worsen materially, Gross Domestic Product growth in the Euro area could still be above 3% in 2022. In this environment, the ECB is likely to stick to its plan and to cautiously remove its accommodative stance.

The US economy is less exposed to Russia and the recovery is unlikely to be derailed. Admittedly higher inflation will be a drag on consumption, but excess savings as well as higher energy related capex will provide some buffer. With an economy at maximum employment, and inflation elevated, the Federal reserve will lean in the direction of a neutral stance and hike its interest rates several times towards 2.25 by end of 2023.

What risks are currently priced in by financial markets?

Equity volatility, particularly in Europe, has entered its highest level, which quite logically reflects the stress linked to the total invasion of Ukraine by Russia, an event that still seemed unlikely at the beginning of February. In terms of the absolute level of volatility, we have not yet reached the peaks known during major crises, which would be a signal of financial market capitulation.

The equity indices have corrected since the beginning of the year. As of 15^th of March, the Euro zone is down around 15%, more or less in line with the American and Emerging markets.  The FTSE100 (United Kingdom) is the most resilient index, only down by around 5%. As for rates, their volatility remains extremely high. Rates fell sharply following Russia invasion of Ukraine and rebounded strongly in the wake of the ECB meeting, reacting to increasing inflationary pressures and the determination of central banks to fight inflation. Finally, commodities, which are the main vector of contagion of this crisis to our economies, have reached new highs (oil price, natural gas in Europe, agriculture, disruption of the nickel market..) before falling back this week. Volatility and counter movements make this market difficult to read and anticipate.

So, what scenario should we take into account today?

if this conflict is resolved quickly and commodity prices continue to fall, then the overall economic damage could be quite limited. The markets could return to their growth trajectory: inflationary pressures would fall and the economic environment would improve. Central banks could pursue their normalization path more serenely. In this context, the most “value” regions such as Europe and Japan could benefit the most from this rebound. Conversely, the deterioration of the current situation could weigh a little more on growth and inflation forecasts, reinforcing the risk of “stagflation” leading ultimately to a “recession”. In this context, the allocation to risky assets should be reduced, while the yield curve should flatten before inverting. The outcome remains thus binary, and uncomfortable for investors. This also explains why outflows from equities have been limited for now.

Armed conflicts do not have a lasting and significant impact on the markets, except when they lead to an energy crisis… which is at stake today.

How have we adapted diversified portfolios since the beginning of this war?

Since early February, we have reduced our exposure to equities by increasing the level of protection in our portfolios. We are actively managing their exposure by positioning for a potentially binary outcome in this crisis, acknowledging upside and downside risks. We increased our exposure to gold, to certain currencies such as the USD, the Yen and the Swiss Franc. We also increased our exposure to commodities (mining and US oil sector) and cut our exposure to financials, the hardest-hit sector since early February. We are maintaining a flexible and pragmatic approach until we have more visibility on the outcome of the war.

A timeline of recent events

What Russia has been asking for?

Russia demanded “security guarantees,” including an assurance by NATO that Ukraine will never join the group and that the alliance will withdraw troops stationed in countries that joined after 1997. Russia considers Ukraine within its natural sphere of influence, and has grown unnerved at Ukraine’s closeness with the West and the prospect that the country might join NATO (or the European Union). While Ukraine is part of neither, it receives financial and military aid from the United States and Europe.

Key recent events

• While over many months, the Russian military moved soldiers and heavy equipment to areas surrounding Ukraine, both the US and Europe offered to negotiate a diplomatic solution. On February 14, Russia said a diplomatic solution was still possible.
• On February 21, Russian President Putin chose to recognize the breakaway Luhansk and Donetsk People’s Republics, in eastern Ukraine. The international community reacted by imposing new sanctions on Russia.
• On February 24, Putin declared the start of a “special military operation” in Ukraine, to “demilitarize”, but not occupy, Ukraine. He said its aim was to neutralize Ukraine and protect Russia. US President Biden denounced Moscow’s “unprovoked and unjustified” attack on Ukraine, pledging the world will “hold Russia accountable” and a new round of sanctions was imposed on Russia.
• On February 27, Russian forces were trying to take control of some of the biggest cities (e.g. Kyiv and Kharkiv) in Ukraine.
• On February 28, negotiation talks between Russia and Ukraine yielded no resolution. Russia began shelling Ukrainian cities.
• On March 8, negotiation talks between Russia and Ukraine’s foreign Ministers made no apparent progress towards a ceasefire

Sanctions decided on February 21-22:

• Besides targeting elites and families close to Putin or some specific entities, U.S. financial institutions were prohibited from participating in the primary market for ruble or non-ruble denominated bonds issued by, or the lending of ruble or non-ruble denominated funds to, the Central Bank of the Russian Federation, the National Wealth Fund of the Russian Federation, or the Ministry of Finance of the Russian Federation. U.S. financial institutions were also prohibited from participating in the secondary market for ruble or non-ruble denominated bonds issued after March 1, 2022 by these entities.
• Europe imposed sanctions against the 351 members of the Russian State Duma, who voted on February 15 in favor of the appeal to President Putin to recognize the independence of the self-proclaimed Donetsk and Luhansk ”republics”; sanctions against an additional 27 individuals; restrictions on economic relations with the non-government controlled areas of Donetsk and Luhansk; restrictions on the ability of the Russian state and government to access the EU’s capital and financial markets and services. Germany also announced it was halting the registration process of the controversial Nord Stream 2 pipeline in light of Russia’s incursion into Ukraine.

Sanctions decided on February 24:

• The US decided to impose new sanctions, cutting off Sberbank from the U.S. financial system; placing full blocking sanctions on VTB and three other Russian financial institutions; imposing new debt and equity restrictions on 13 enterprises and entities; targeting seven Russian elites and their families; and hitting 24 Belarusians for supporting Russia’s invasion. Export restrictions were also imposed on telecommunications- and technology-related equipment to limit Russia’s ability to advance its military and aerospace sectors.
• Europe also took further sanctions against Russia targeting the financial sector but also prohibiting exports of refinery equipment and airplanes (including spare parts).

Sanctions decided on February 27:

• Selected Russian banks were removed from the SWIFT messaging system. This will ensure that these banks are disconnected from the international financial system and will harm their ability to operate globally.
• The Russian Central Bank will be prevented from using its international reserves. However remember that besides Russia holding a significant amount of gold (roughly a quarter of its $634 billion of reserves), the Russian central bank has diversified the location where it holds its reserves, with China being now its biggest depository.

New sanctions decided on March 8-11

• US President Biden announced a ban on fossil fuel imports. Earlier, the UK announced it intends to stop buying Russian oil by end 2022 (UK sanctions won’t apply to natural gas).
• EU extended sanctions to Belarus (a SWIFT ban, a prohibition on transactions with the Central Bank, limits on the financial inflows from Belarus to the EU, and a prohibition on the provision of euro-denominated banknotes to Belarus).
• Restrictions on the export of maritime navigation and radio communications technology to Russia were imposed.
• A ban on exports of EU luxury goods to Russia and imports of iron and steel goods from Russia was also decided.

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