The Allies have announced a new slate of sanctions against Russia, partially cutting Russia from Swift. In particular it was decided that:

- Selected Russian banks were removed from the SWIFT messaging system. This helps disconnect these banks from the international financial system and harms their ability to operate globally.

- The Russian Central Bank (“CBR”) 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.

For the time being, sanctions are meant to be narrowly targeted so as not to directly affect Russian commodity exports. The United States and Europe are trying to coordinate with SWIFT to find ways to identify energy transactions in the system and to exempt certain banks to limit the potential for disruption. This may however prove to be a delicate operation… and Russia could easily escalate by cutting its energy flows to Europe.

The Russian economy is likely to be severely impacted by this new round of 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 rubble (“RUB”) depreciation (the RUB has already depreciated by 30% 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.

Our macro-scenario for the Euro area:

While the probability that we will end up in a “worst-case” scenario – where harsh sanctions on Russia impact the energy sector – has increased, for the time being, sanctions have been narrowly targeted in order not to directly affect Russian commodity exports.

Still, the crisis will delay the normalization of supply chains (Ukraine supplies more than 90 percent of U.S. semiconductor-grade neon while almost 50% of palladium, a rare metal also used for semiconductors, is sourced from Russia), while energy prices will be more elevated than envisaged a few months ago. Some offsetting fiscal measures are likely to be implemented to soften the blow – for example, Italy has already approved a €8 billion aid package for energy and auto sector relief while Germany has pledged to increase its defense spending. If tensions on the energy market do not worsen materially, Gross Domestic Product growth in the Euro area could still be above 3.5% in 2022, but risks are to the downside. With inflation high, the central bank’s task will prove to be a delicate balancing act but, given the risks to growth, the European Central Bank is likely to be more cautious in shifting its monetary stance.

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, but unevenly. As of 1 March, the Euro zone is down around 15%, the American market by 10%, while the FTSE100 (United Kingdom) is almost stable. As for rates, after a relatively calm week, rates fell sharply on Tuesday March 1, particularly in Europe, which suggest that we are entering a more significant risk-off phase. Finally, raw materials, which are the main vector of contagion of this crisis to our economies, are progressing considerably. Brent oil hit new highs, industrial metals and agricultural commodities are on the rise and gold is fulfilling its role as a safe haven.

Things are changing very quickly and until this week, we could say that the markets were counting on a rather rapid resolution of the conflict, without any major impact on our economies. We are at a tipping point. On the one hand, the US market is benefiting in relative terms from the fall in interest rates and more moderate expectations of monetary tightening by the Fed in the short term. This benefits growth stocks and defensive stocks, which should perform better. On the other hand, we are assessing the impact of the sanctions with the fear of an energy shock that would undermine growth, in Europe as in the United States. The volatility observed in recent days reflects the uncertainty as to the outcome of this war — duration of the military conflict, energy shock and sanctions, the situation remaining relatively binary until today.

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.

In early February, we 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 it 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.

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 sector.

• Europe also took further sanctions against Russia targeting the financial sector but also prohibiting exports of refinery equipment and airplanes (including spare parts).

The authors

Nadège Dufossé Global Head of Multi-Asset and Florence Pisani Global Head of Economic Research

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