Special Report, Outlook 2015: War on Europe’s frontier
“This whole year it’s been spoiling the mood of the investor,” says Asoka Wöhrmann, CIO at Deutsche Asset & Wealth Management.
He is referring to the way Ukraine’s civil war has hovered over European markets like a dark cloud. Fighting between pro-Western forces and pro-Russian separatists has not spread beyond Ukraine’s borders but the negative sentiment across Europe is palpable. There is also an outside chance that the mutual recriminations and sanctions between Russia and the west could spin out of control. If that happens the economic and financial effects could be substantial.
It would be easy to take heart from Ukraine’s relatively marginal position. Spain provides a useful yardstick; Ukraine’s land mass is slightly bigger and its population slightly smaller but Spain’s GDP is more than four times that of the eastern European state.
In stock market terms the Ukraine is virtually insignificant. Ukrainian stocks accounted for less than 0.15% of the MSCI Frontier Markets index a year ago, before the fighting broke out. The total capitalisation of the Ukrainian exchange is equivalent to €15bn – far smaller than many of Europe’s largest companies (although some Ukrainian firms are listed outside the country).
However, it would be wrong to dismiss the risks resulting from Ukraine’s bloody strife so easily. On the centenary of the outbreak of the First World War, it is worth remembering that that conflict was precipitated by an archduke’s assassination in a small kingdom – international tensions can spread unpredictably.
One way to examine the likely repercussions of conflicts is to begin at the centre and work outward. In this case it means starting by examining the impact on the Ukraine before looking at what it means for Russia and for other parts of Europe.
Ukraine’s frozen conflict
After months of civil war, Ukraine is locked into what is sometimes called a frozen conflict. A shaky ceasefire has more or less held since September, despite violent clashes around Donetsk airport and elsewhere, but the combatants’ grievances have not been resolved. Until a political solution is found, there is always a chance that full-scale war could erupt again or the country could even fracture into two parts.
It is important to remember that Ukraine’s economic hardship long predates the armed conflict. As Marcus Svedberg, the chief economist at Stockholm-based East Capital, says: “the economy was already in dire straits”. It is one of the countries that have done worst from the demise of the old eastern bloc. By 1999, output had dropped by 60% compared with when it gained independence in 1991, according to World Bank figures. The 2000s were generally better but in 2009 GDP slumped again, by nearly 35%. Indeed one of the factors that triggered the conflict was an internal row over whether to accept rescue packages from the EU or from Russia.
At a glance
• Although the Ukrainian civil war is a human tragedy, its direct impact on the European economy and financial markets is minimal.
• Western sanctions are starting to hurt the Russian economy.
• The potential impact of rising tensions between the West and Russia varies enormously between different countries.
• There are limits to what asset managers can do to protect themselves against the effects of any escalation.
Svedberg is critical of all external parties for making the Ukraine choose one over the other. “It was handled extraordinarily badly by the west and obviously by Russia as well,” he says. “Everyone was making Ukraine pick sides.”
Having just regained pre-2009 levels, 2014’s GDP is now expected to show a fall of up to 10%. The situation in eastern regions of the country, such as Donetsk and Luhansk, is particularly dire. The IMF estimated in its September country report that the likely decline of output in the east will be 15-20% this year.
The financial effects are also dramatic. The hryvnia fell sharply earlier in the year. As a result, companies that borrowed in dollars have struggled to repay their loans. Mriya, an agricultural firm, and Metinvest, a metals exporter, are among those trying to restructure their bonds. More generally, bond spreads have suffered extreme volatility.
For western investors the direct financial impact of the tragedy is likely to be minimal. Even specialist emerging European portfolios seldom have significant holdings in Ukrainian assets. Any effect on western investors is likely to come as a result of spillover effects.
Besides the Ukraine itself, the country most affected by the conflict is Russia. Western sanctions, imposed initially in protest at its annexation of Crimea in March 2014, were symbolic at first. But they have already started to hit, with a heightened impact likely over time. The range of sanctions is varied but it includes travel bans on named individuals, a ban on certain business transactions and restrictions on credit financing. Russia has responded with sanctions of its own, including a ban on food imports from the US and the EU.
The Russian economy, like that of Ukraine, was already performing poorly before the crisis hit. GDP only grew by 1.3% in 2013, with the IMF predicting an expansion of 0.24% this year in its October forecast. Sanctions are already making matters worse by weakening the rouble. As a result, Russia is suffering capital flight rather than enjoying the inward investment it requires.
“Russia badly needs foreign investment to sustain its long-term growth,” says, Michel Danechi, a portfolio manager at the EI Sturdza Strategic Emerging Europe fund. Insufficient investment will also undermine Russia’s ability to diversify and modernise its economy.
Peter Havlik, a senior economist at the Vienna Institute for International Economic Studies, identified two additional channels through which sanctions could hit Russia. Speaking at a recent webinar, he argued that economic hardship and financial instability could erode support for the ruling elite. Although president Vladimir Putin’s poll ratings are high at present, that might not last. Havlik also argued that the effect of sanctions could hinder attempts to integrate Russia, Belarus and Kazakhstan into a Eurasian Economic Union.
European tail risk
The effects of the Ukraine conflict on the rest of Europe are difficult to untangle from the negative impact of the euro-zone’s own debt crises and economic slowdown. Even those countries outside the currency union are likely to be affected by the region’s economic troubles. The Ukraine crisis has simply compounded the challenges.
Peter Havlik argues that the impact of the Ukraine crisis will vary widely between countries. “We cannot speak about the impact on the EU,” he says. “We have to talk about the impacts on the individual European countries.” He calculates that the Baltic states of Estonia, Latvia and Lithuania are the most exposed in terms of trade in goods. Perhaps more surprising is that Cyprus is also vulnerable because of its dependence on Russian tourism.
Svedberg says that the Ukraine conflict has soured relations between Scandinavia and Russia. He points to Sweden’s week-long hunt for a Russian submarine allegedly lurking in the Stockholm archipelago – within shouting distance of East Capital’s headquarters – as symptomatic of rising tensions. In his view, the growing hostility is mutual.
A potential wild card would be if Russian energy exports to Europe were disrupted. Since energy accounts for 80% of EU imports from Russia this is perhaps the most likely channel for a generalised effect across the continent. Danechi of El Sturdza, says: “If there a disruption of the gas supply it would make life difficult for everyone concerned.” However, he believes such a scenario is extremely unlikely as both sides have an interest in avoiding such an escalation.
Greg Konieczny, a fund manager at Romania’s Fondul Proprietatea and a vice-president at Templeton Emerging Markets, points out that some firms could, in fact, gain from a further escalation of Russia-EU tensions. “Companies that should benefit from this scenario are energy and utility companies”, he says.
Nevertheless, the broader impacts of any escalation would be so disparate – as well as being mixed in with the effects of the euro-zone slowdown – that it is difficult to see what individual asset managers can do besides maintaining well-diversified portfolios. It is certainly hard to envisage how managers can anticipate the effects of a tail risk that could have unpredictable consequences – although at least one European pension fund, The KLM Dutch pension fund for ground staff has reported that it divested its entire holdings in Russia in Q3 2014, having decided that the potential for escalating sanctions presented too big a country risk.
“There is no standardised protection mechanism,” says Wöhrmann. In his view, the best approach “is to stay up-to-date with developments”.
Besides being diversified and ready to respond to events, that means hoping that politicians and diplomats will find a lasting solution. The roots of the conflict are not economic or financial and its resolution also lies outside of these spheres.
Konieczny is probably more optimistic than many when he says that tensions “should gradually die down”. But he adds: “We are not talking about months but a year or two, or maybe even three years, before a final resolution to this conflict is found.”