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A New World Order: The impacts of the Ukraine War

By Gustavo Medeiros

We discuss a few impacts of the war, including:

  1. Inflationary shock: commodity and supply chain
  2. Liquidity shocks via the financial sector
  3. A new world order: Putin regime downgraded back to USSR status
  4. Ukraine gloomy fate and scenarios for the conflict
  5. De-globalisation. The main implications across different regions
  6. Global capital allocation: the role of Emerging Markets and reserve diversification

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Transcript is available below.

Transcript

Stephen Rudman: Good day, my name is Stephen Rudman. I'm part of the Ashmore, New York-based, US distribution team. I'd like to welcome you to today's video, which will specifically address the issues surrounding the Russian-Ukraine military action, as well as the fallout, potentially, for investors worldwide. Today, we have Gustavo Medeiros, the Head of Research of Ashmore, to share his thoughts. I'd like to start with the concept that this is a key moment in history. Gustavo, how has the world changed, and what are the impacts for global investors?

Gustavo Medeiros: Thanks, Stephen, indeed, much has changed over recent weeks. I think it was Lenin who said there are decades where nothing happens, and there are weeks where decades happen. There is a lot to unpack and consider, given the situation in Russia-Ukraine. There's going to be a massive impact for global investors as well.

But the first and most important impact we're seeing on a daily basis is the impact on inflation. The invasion of Ukraine by Russia, and the sanctions imposed by Western countries, means that a very large portion of commodities and the trade of non-commodities goods has been completely disrupted. That is leading to probably one of the worst supply shocks we've seen since the 1970s. And inflation was already a significant problem on a global perspective before the war. If you look at producer price index inflation levels, we were already in double digits across the world. In Europe, inflation in February was at 30.5%, if I'm not mistaken. In Turkey, the worst performing emerging market country from the large liquid countries, the producer price inflation was at around 105%. But broadly speaking, producer price index inflation has been at double-digit levels across the entire G20 because of the expansive monetary and fiscal policies implemented due to the COVID crisis.

Now, we have war between Russia, probably the main commodity superpower in the world, and Ukraine. Therefore much of the exports of commodities has been totally disrupted and that will have a significant impacts across the world. Obviously, energy importers, food importers, and base metals importers will be suffering, but there will also be a direct impact on the global financial system, as liquidity gets impaired as a result of collateral calls, margin calls, etc. To give you a few numbers, Russia is responsible for about 21% of the global palladium production, 13% of the global platinum, 10% of all gold and nickel exports, and about 5% of uranium, iron ore, and silver. So, not coincidentally, prices across all these commodities are sharply higher.

But, most obviously, energy is the elephant in the room. Russia is responsible for about 20% of the global natural gas exports to the world. Europe is the most dependent region from Russian exports of energy, in particular, natural gas. Russia is also responsible for about 12% of all crude oil exports and 10% of all aluminium. Further, between Russia and Ukraine, they're responsible for about 25% of the global export of wheat, a key component of the food chain across the entire world. So, that's the primary impact.

Russia and Ukraine are also key suppliers of very important metals and special gases – like titanium, as well as neon and xenon gas, for example – that are either components or sub-components of technology products and manufactured products. That will also have an indirect impact, as well, on global supply chains. On a direct basis, Volkswagen and BMW have already announced they have had to shut down plants in Germany and Poland as a result of the sanctions imposed in Russia, and that they cannot get parts coming from Kaliningrad, to manufacture cars that were an enclave between Poland and Lithuania, and also other parts of Russia.

So, a massive inflationary shock that is equivalent to the 1970s is the first and most important shock we must consider. The second shock we anticipate is a strong liquidity shock, to the extent that commodities are one of the most important ways of measuring the value of money. We have already seen rapid spikes in commodity prices, such as nickel doubling in price, while European natural gas has increased 240%. This also has a massive impact on the money market. Simply speaking, if you're a commodity trader, and you're operating on a leveraged basis, you simply need more lending to be able to trade these commodities. If you have structured operations where you were long the spot of the commodity and short the futures, for example, you're going to have massive collateral margin calls daily.

And that's before we start talking about the impact of removing all Russian assets and Russian-owned assets from the international system. Russia had $1.6 trillion of securities overseas, with approximately $600 billion dollars held by the central bank in the format of gold and FX reserves. FX reserves denominated in dollars and euros have been frozen for the moment. So, there’s now a shortage of collateral, for example, of German bonds that were held by the Russian central bank. That is going to lead to a shockwave across the liquidity system. It’s hard to hard to predict how this liquidity shock is going to end, but we know it is already beginning.

One of the analysts we follow said, "If you think that you can implement or impose such draconian sanctions to the Russian financial system without having any impact on the Western financial system, you might as well believe in unicorns”. I think he's pretty spot on here. The ultimate impact of the sanctions imposed won’t be clear for a few weeks, months, or even quarters.

The other consideration to think about is the geopolitical impact. You may try to call it the 'New Old World Order' to the extent that we are back to very similar dynamics to the Cold War. Putin's regime has effectively downgraded Russia to USSR status, and we’re watching,  on a daily basis, the West trying to remove Russia from its global economic system. Therefore, Russia will have to close itself to the rest of the world with a few exceptions of countries that have no alternative but to keep trading with Russia, such as Kazakhstan and  Kyrgyzstan. China perhaps might step in and become an even more important trading partner for Russia. That's going to have important consequences for geopolitical considerations.

Regarding Ukraine, it has historically and tragically been a buffer zone between Europe and Russia, a role that has come back to haunt Ukraine again. The West took a share of responsibility since the end of the Cold War, increasing the size of NATO and expanding NATO very close to the Russian borders. Even though Putin drew a red line in with the annexation of Georgia in 2008, and conflict again in Ukraine in 2014, the West continued to provide weapons for Ukraine, and was unable to, or unwilling to negotiate any resolution to the impasse. Ukraine is extremely important for Russia and not that important, unfortunately, for the United States, which is leading NATO. Therefore, Russia has the upper hand with NATO.

There are a number of scenarios for how the conflict can evolve. The base case scenario for now is that the conflict lasts for a long period until Putin achieves his objectives, which is to demilitarise Ukraine completely, have some sort of change in leadership and obtain a guarantee that Ukraine will never be a part of part of NATO, and perhaps not even a part of the European Union. In fact, Russia has already declared three conditions for a ceasefire: recognise Crimea as part of Russia, recognise Donbas, which is Donetsk and Luhansk as independent states, then asking for Ukraine to draft, to write in its constitution that Ukraine will never be part of NATO. The Ukrainians are unlikely to abide to all these terms, particular the requested regime change. If we don't get a ceasefire in the short term, the situation is likely to remain very precarious for the unfortunate population of Ukraine on the ground, to extent that the bombardment of cities, as we're seeing in Mariupol already, as we're seeing in different parts of Ukraine, is likely to continue. Eventually, we could have a situation where Ukraine is forced to split its territory or give up some of its sovereignty in the name of peace.

Finally, there is a final, worst-case scenario of escalation. Now that Belarus has Russian troops permanently stationed in its country, it may try to again extend the territorial possession of Russia all the way from Kaliningrad, all the way south potentially to Georgia via, again, East Ukraine. That would be the worst-case scenario to the extent that it would demand a firm response from NATO, threatening a direct conflict between these two forces.

The additional theme that emerges from that is de-globalisation, and the question of what would be the impact of de-globalisation across the different parts of the world? Countries in the Commonwealth of Independent States (CIS) like Kazakhstan and Uzbekistan that used to form part of the Soviet Union still play an important role as part of the Russian economy, but also having very strong and important ties with the Chinese economy. Obviously, the economies of these countries will suffer a shockwave along with Russian financial markets, but perhaps they can benefit in the medium term of becoming key trade centres between these two regions, and even take advantage of any arbitrage opportunities that build up.

The second region to come to mind immediately is Eastern Europe, obviously. The negative potential consequences include the fact that most Eastern European countries have been key members of NATO since the 1990s, and therefore they are on the front line following Ukraine against the Russians. Any direct, or even indirect confrontation would see these countries suffer. Also, we are already seeing a huge amount of people fleeing Ukraine into neighbouring countries, particularly Poland and Hungary. While the initial impact is negative to the extent that economies have to absorb the cost of paying for these immigrants, in the medium to long term, that demand shock should be positive for these economies.

Another potential positive is that both Poland and Hungary had been gravitating towards the far right politically over the past decade. Now these countries are signalling they will swerve closer to the European Union, and that close reliance should be positive for these countries. They should benefit from EU funds for diversification of energy away from dependency on Russia. They should also benefit from higher spending on the military.

The Middle East is also going to have a very key role. As yet, OPEC+ has not announced an increase in oil production, despite the cost of oil rising from $90 to $130 per barrel. The Middle East used to be controlled tightly by the United States in geopolitical terms. But more recently, Middle East countries have been gravitating more towards China and Russia as well. Now it appears that oil-producing counties that had previously been cut out of the Western financial system, such as Iran and Venezuela, are going to have to be brought back in.

Finally, the other key region to consider is Asia, and whether this conflict raises a question mark over China’s territorial dispute with Taiwan. However, I would suggest that China probably believes that time is on their side. China has a growing economy which has been an increasingly important commercial partner across most of the world. That growing importance in the global economy, and as a key trade partner, means it has stronger ties with the rest of the world, and it would be harder for the US and Europe to implement the same sanctions as have been imposed on Russia. Most countries would simply not be able to break trading ties with China. Also, Chinese leadership has believed for a long time that eventually Taiwan will be better off merging its economy with China, so playing the long game makes more sense for them. Even so, it’s a political fault-line that will need to be monitored closely.

And finally, there’s the impact for global capital allocation. The key question to answer is, what is the role of EM in global portfolios following a shock where Russia, a large EM (and G20) country becomes uninvestable overnight?

It’s interesting that the knee-jerk reaction is to think that EM is a problematic place to invest, but if you think about it in pragmatic terms, if you want to hedge your global portfolio against inflation, the best portfolio hedges are probably found in emerging market economies, like Latin America, the Middle East, Africa, and some Asian economies that are net exporters of commodities, energy, industrial metals, and food. These countries will find more capital willing to invest in these economies, and the positive terms of trade impact is likely to be beneficial to these economies as well. So, one of the few places where you can still find some degree of inflation protection, when you think about global fixed income, is probably an emerging market fixed income. In emerging market equities, it’s the same story we've been talking for the last three to five years: valuations are very much discounted. You have a number of key players on the commodity markets trading at extremely attractive levels of valuations that you would struggle to find at similar valuations in the developing world.

Also, I think the trend of the renminbi becoming a key currency for reserve management purposes, is going to accelerate. More and more countries will find it very attractive to have more off-system reserves away from the US dollar and the euro, and simply speaking, the renminbi and gold are the best alternatives for that. It's probably a lifeline of the Russian Central Bank at the moment that it can repo gold against the renminbi and pay for the imports of goods. It can also repo gold against other currencies that are not implicated on the sanctions to trade other goods as well, and use it for other commercial transactions. So, in a scenario where there’s an acceleration of diversification away from the US dollar as the key currency for reserve management purposes, then obviously China stands to benefit the most.

Those were the most important considerations I wanted to bring up. So, with that I will hand back to you Stephen for any further questions. I'm also happy to organise follow up calls or webinars to talk further about any part of the discussion.

Stephen Rudman: You have certainly covered quite a lot there. Let’s finish with one last question. Is there any unknown risk that hasn’t been in the headlines but is a ‘wild card’ that we should be thinking about?

Gustavo Medeiros: Yes, I think there are a lot of left field, unseen risks that could hit the global economy. For example, the risk of cyber-attacks has increased quite significantly. Russia is yet to retaliate after the sanctions imposed by Europe in using its aerospace, for example. I think that there was already very strong competition in the cyber space for the control of different payment systems, control of different infrastructure that is key for our online economy today, and this cyber war is an important one to monitor.

Thinking back to during the Cold War, we had the so-called ‘Space Race’ as a key feature, and that could be coming back into vogue. For example, in November last year, it hit the headlines that Russia now has the ability of firing a rocket from Earth’s orbit to destroy satellites in space. Controlling communications is a key element in any international conflict. And obviously, the war on information – or disinformation – where social media plays a role, could become another key battleground. We've seen that in different elections in the Western world, but now a good part of the Russian population is getting completely different coverage of the events happening in Ukraine compared to viewers in the West. Public opinion is a very important weapon, and I would watch for those left-field events that are not being very well covered to deliver surprises in the geopolitical space.

Stephen Rudman: Gus, thank you. Very helpful, and very thorough. I think for today, we can call it a draw. Most importantly, to all the people watching, don't hesitate to reach out to your contacts here at Ashmore. We're doing our best job to push information out to you, but if you'd like to discuss any aspect, please don't hesitate to reach out. Gustavo, thank you and we hope everyone listening has a great day. Thanks.

Gustavo Medeiros: Thank you very much.

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