Ramifications between Russia and Ukraine: not all exchanges are created equal
Every time motorists pump gas these days, they get a painful reminder of Russia’s role in world oil markets. What has been less appreciated is the range of raw and semi-finished products that Russia and Ukraine export. From palladium to wheat, disruptions are already putting upward pressure on the prices of a range of everyday products, increasing macroeconomic and market risks in the coming quarters.
At first glance, Russia and Ukraine should not matter much to global economic activity. Ukraine’s share of world exports is only 0.3%, while Russia’s is 1.9%. In contrast, China and the United States each account for around 10% of world trade.
Yet it’s a radically different story when it comes to key industrial inputs. As the chart shows, Ukraine and Russia are major exporters of palladium, nickel, grain and other resources that are essential to a variety of goods and industries – from cars to semiconductors to through groceries.
Consider palladium, a chemical element and rare precious metal with a silvery-white appearance. Russia produces over a third of the world’s palladium, much of which is for export. In addition to jewelry and dentistry, palladium is used to make catalytic converters that reduce pollution from exhaust gases from internal combustion engines. They are mandatory in many countries. So auto production — already slowed by pandemic-related and supply chain shortages of semiconductors — faces further disruption.
Palladium is just one example. Other major manufacturing inputs include fertilizers for agriculture, neon gas for semiconductors, nickel for steel, and ammonia for plastics.
Commodity markets have been quick to price in imbalances between supply and demand, but we believe economists and equity investors are lagging behind in assessing the impacts on growth and corporate earnings.
Shortages of primary inputs will be felt on the demand and supply side of the equation. This risks snowballing and non-linear negative impacts on broader economic growth while pushing inflation higher.
Second-order effects are already being felt as rising input costs push prices higher, in some cases leading to demand destruction. In recent weeks, Europe has been hit by reduced or suspended production at some steel, fertilizer and paper manufacturing plants. The auto sector, already reeling from semiconductor shortages over the past 18 months, has slowed production, leading industry experts to predict more delays and disruptions in the coming months.
Although the interdependencies and pass-through effects are complex and difficult to quantify, rising prices and demand destruction will slow growth and put upward pressure on prices, prompting central banks to tighten policy. faster than they otherwise would have been.
Naturally, Europe will likely be the hardest hit due to its proximity and economic ties to the fighters. Nevertheless, the interconnectedness of the global economy means that ripple effects will ripple, from food prices in Egypt to children’s toy prices in the United States.
Importantly, as stated in our Cyclical outlook“Anti-Goldilocks”, the disruptions come amid high economic uncertainty with high inflation, slowing growth and tighter financial conditions, leading to a fragile and precarious market environment over the coming quarters.
For multi-asset portfolios, we believe this requires a more defensive stance and a focus on quality and liquidity, as the risk of recession increases on the cyclical horizon. Investors may want to avoid more cyclical sectors within equities, particularly in Europe where the economic cycle looks most vulnerable in the near term, in our view.
Instead, we favor high-quality stocks with pricing power and sustainable earnings growth, in areas such as semiconductor manufacturing and healthcare. We also like companies that can offer sustainable growth potential in a slower growing world, in areas such as renewable energy and automation.
At the asset allocation level, our strategy has been to broaden potential return drivers to interest rate and currency markets where we see the best value, such as an emerging currency market. We aim to maintain low overall directionality while being proactive in our risk management.
As always, volatility presents both risks and opportunities.
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