Ukraine Archives

Key points

We are witnessing a divergence between the outlook for developed-market and emerging-market inflation.
China is playing a key role as an exporter of lower inflation to emerging markets as trade and investment integration increases within the bloc, just as China’s trade with the US and many western countries reduces.
Many developed-market central banks continue to tackle above-target inflation following an extended period of excessive monetary and fiscal easing, trade protectionism, labour-market tightness and continuing supply-chain disruptions.
Conversely, many emerging markets avoided excessive monetary and fiscal stimulus during the pandemic and, when global inflationary pressures were rising in 2021 and 2022, positioned themselves ahead of the curve in terms of hiking interest rates.
We believe that lower emerging-market inflation dynamics will enable central banks to reduce rates further than consensus estimates, boosting emerging-market local-currency bond returns and providing the conditions for a lower cost of capital to support emerging-market equity markets.

The world is facing very different inflation dynamics as a divergence between the outlook for developed- market and emerging-market inflation takes place. At the heart of this dynamic is China’s role as an exporter of lower inflation to emerging markets as trade and investment integration increases with the bloc.

Cheaper emerging-market commodity availability, owing to Russia being shut out of developed markets, is also a boon to emerging-market inflation. We believe that lower emerging-market inflation dynamics will enable central banks to reduce rates further than consensus estimates, boosting emerging-market local-currency bond returns and providing the conditions for a lower cost of capital to boost emerging-market equity markets.

Excessive monetary and fiscal easing

While most developed-market central banks continue to tackle above-target inflation following an extended period of excessive monetary and fiscal easing, trade protectionism, labour-market tightness and continuing supply-chain disruptions, the dynamics facing many emerging markets stand in stark contrast. Many of the latter avoided excessive monetary and fiscal stimulus during the Covid pandemic and, when global inflationary pressures were rising in 2021 and 2022, they positioned themselves ahead of the curve in terms of hiking interest rates.

Furthermore, emerging markets have generally remained more open to free trade and less protectionist, and output gaps (particularly in certain Asian economies) have remained negative, which has eased the inflationary burden. While we expect inflation in developed countries to come down in the near term, we believe that it will remain volatile and prone to upward spikes as experienced during the 1970s. This is partly because western central banks will come under increasing political pressure to reduce interest rates at the earliest opportunity and partly because we now live in a volatile geopolitical world in which cost-push supply shocks are an increasing phenomenon.

However, if there is one inflationary dynamic that will favour structurally lower price rises in the emerging world versus the developed, it is the former’s constructive trade and investment relationship with China, while the developed world continues to reduce ties and increase protectionism.

China – exporter of low inflation

China experienced consumer price deflation over the second half of 2023 and producer price deflation for the whole of 2023. Since the Covid pandemic, Chinese consumers have saved an extra 4% of their incomes on average. Savings rates were already high in China but remain extremely elevated at 35% of disposable income (see chart below).

China household savings rate (% of disposable income)

Source: Macrobond, January 2024

Because of China’s economic model and long-term high savings rates, the country has had a historically high level of investment to GDP. This time around, however, investment in the real-estate sector is off limits owing to the policies and resulting downturn in this sector. Instead, investment has been increasingly channelled into manufacturing investment to fulfill the Chinese Communist Party’s quality-growth target (see chart below).

China’s fixed-asset investment in manufacturing (cumulative year-on-year over last five years%)

Source: Macrobond, January 2024

Such high levels of manufacturing investment have resulted in excess industrial capacity in certain sectors, thereby causing producer price deflation and affecting industrial profits (see chart below).

China’s industrial capacity utilisation v producer price inflation (PPI) and industrial profit growth

Purple line China PPI year-on-year (%) rhs, green line China industrial enterprises total profits (%) rhs,

Dark blue line China utilisation rate of industrial capacity, lhs

Source: Macrobond, January 2024

Because China is producing more than its domestic requirements, the resulting increase in exports has led the country’s trade surplus to surge over the last few years to an annualised level of c.US$450bn (see chart below).

China’s trade balance (billions of US dollars)

Source: Macrobond, January 2024

Developed-market versus emerging-market protectionist response

The consequence for China of operating such an economic model (i.e. insufficient domestic consumption, excessive domestic investment, large state subsidies) is that it risks upsetting trade partners. Large tariffs remain in place from the US, and we suspect that these are only likely to increase under a potential ‘Trump 2.0’ administration. Meanwhile, the European Union (EU) announced an investigation into Chinese electric vehicle state support and unfair competition in the fourth quarter of 2023. While the US and EU still comprise more than 25% of China’s total exports, this share has been declining in recent years. (See chart below).

Changing destination of Chinese exports between 2017, 2021 and 2022

Source: World Bank, Trading Economics, Newton Investment Management, January 2024

We contend that the majority of China’s trade partners in the ‘Global South’ (non-G7 countries) want open trade with China and are less likely to resort to protectionist measures. This is in large part because China buys their commodities and invests in their infrastructure. In the case of Asia, China is part of the Regional Comprehensive Economic Partnership (RCEP) trade group, which was established in 2020, with the aim of reducing tariffs between members. The group is comprised of 15 countries representing 30% of global GDP and growing.

As Chinese trade and investment integration with both the RCEP and African and Latin American countries grows, China will be exporting lower inflationary forces, thereby helping to keep interest rates lower across the emerging-market bloc. We believe this is good news for emerging-market local-currency bonds, which we expect to perform strongly over the coming months. By contrast, protectionist measures by the G7 will continue to limit China’s incremental access to these markets, which means the G7 will miss out on the lower goods price inflation that China can provide. (See chart below).

Developed-market versus emerging-market inflation (%)

Source: Bloomberg, Newton Investment Management, 10 January 2024

Russia’s role

While this article has focused primarily on the disinflationary impulse from China to other emerging markets in the bloc, Russia is playing a similar role in the commodities sphere. With Russian commodity exports locked out of G7 markets, Russian oil, gas, food and metals have been diverted to emerging markets, often at steep discounts to international benchmark pricing, as Moscow’s customer base was curtailed. Given the continuing war in Ukraine and Moscow’s ascendency on the battlefield, it is unlikely that this commodity export dynamic will change in the near to medium term.

Investment implications

While conditions in developed markets point towards more elevated and volatile inflation over the next decade in a potential echo of the 1970s, we believe that inflationary conditions in many major emerging markets are very different, owing to disciplined and proactive monetary and fiscal policy, less tight labour and industrial markets and, most importantly, constructive trade relations with China (and to a lesser extent, Russia).

This will help reduce the emerging-market local-currency cost of capital, which could be a benefit to both emerging-market local-currency bond and equity holders. In our view, investors should consider being overweight in both emerging market (ex China) bonds and equities in 2024.

Key Points

With Russia on the backfoot as Ukraine steps up its counter-offensive, Ukraine’s President Zelensky is incentivized to push to regain as much territory as possible over the coming weeks.
However, with US elections in 2024 and US military aid to Ukraine already costing $60bn, President Biden will be keen to show his electorate some progress and avoid another American ‘forever war’.
Although there may well be more bloodshed in the weeks and months ahead, we anticipate that peace negotiations may commence in the coming months.
We believe it is likely that the European Union will need to fund the lion’s share of Ukraine’s reconstruction – perhaps as much as 70% or €700bn.
Equity sectors we believe could present opportunities include the obvious beneficiaries of physical reconstruction: construction, building materials, industrials and utilities.

In this blog, we explain why we believe the Wagner Group’s mutiny and early-stage coup on June 23-24 could be a potential gamechanger for the war in Ukraine. Although Wagner stepped down just 200km from Moscow in a deal brokered by Belarus’s President Lukashenko, Russian President Vladimir Putin’s leadership and scope for strategic flexibility appear to have been compromised.

The mercenary group’s leader, Yevgeny Prigozhin, laid bare the enormous folly, false pretenses and human cost of the war in Ukraine, while leaders from Russia’s military stood aside as his group occupied the city of Rostov-on-Don in southern Russia.

With most of the Wagner paramilitary group disbanded or in Belarus, the Russian war effort has lost its most potent and effective fighting force. It is likely that Putin must now be hyper-sensitive to the risk of sending additional resources (men) to perish in Ukraine as it heightens the risk of social instability at home and the prospect of further plots against his regime. To us, it seems that maintaining Russia’s chances of winning (not losing) the war in Ukraine will come at the cost of domestic stability: battlefield success and Russian domestic stability could be mutually exclusive outcomes.

Earlier Timeline for a Peace Deal

With Russia’s existing occupation of most of Donetsk and Luhansk creating a land bridge to Crimea, and facing the strategic risks highlighted above, we believe that Putin’s best move now would be to sue for peace. As such, we would expect back-channel peace negotiations sponsored by major actors including China and Turkey to step up over the coming weeks.

With Russia on the backfoot as Ukraine steps up its counter-offensive, Ukraine’s President Zelensky is incentivized to push to regain as much territory as possible over the coming weeks, and thus we believe it extremely unlikely that Ukraine will accept a peace offer in the first instance. The US and its NATO allies will also want to push for Ukraine’s maximum territorial reclaim and possibly test the stability of Putin’s regime.

Avoiding a ‘Forever War’

However, with US elections in 2024 and US military aid to Ukraine already costing $60bn, President Biden will be keen to show his electorate some progress and avoid another American ‘forever war’. In short, we anticipate that peace negotiations are likely to commence in the coming months, with a 60% chance of a ceasefire or peace deal by year end.

Sadly, this does not preclude the prospect of extremely violent and bloody warfare in the next few months as Ukraine and NATO push for maximum advantage. What the Wagner insurrection has done is to shift the Russian calculus in favor of an early peace deal in order to minimize domestic damage. This appears likely to mark a significant strategic shift from the prior focus on playing the long-game war of attrition.

Rebuilding Ukraine

Any peace negotiations will be centered on three key issues: defense guarantees for Ukraine, the territorial limits of either side (including demilitarized zone), and how the reconstruction of Ukraine will be financed. We examine these factors below:

The reconstruction of Ukraine including its physical and social infrastructure is likely to cost up to €1 trillion[1] (for context, eurozone GDP is c. €15 trillion) over five to 10 years, or some US$100-200 billion per year.
This could prove a conservative estimate; the reunification of Germany cost an estimated €2 trillion over 20 years, but East Germany was not a war zone with 8 million+ people displaced.
The total population of East Germany in 1990 was 16.1 million, just over a third of Ukraine’s population today. Furthermore, the €2 trillion reunification cost was nominal. At inflated 2023 prices, this cost would be much higher.
There has been recent debate in European Union (EU) circles as to whether Russia’s seized international reserves could be used to help fund the reconstruction. The latest sentiment by EU leaders appears skewed against doing this on legal grounds, and because of potential international repercussions for the euro if foreign-exchange reserve holders begin to de-risk euro exposure as a consequence.
Despite these reservations, our view is that any peace deal with Russia will still be likely to feature a role for its confiscated international reserves. A reasonable assumption would be that 50% or c.US$150 billion could be requisitioned to help finance the reconstruction of Ukraine.
Europe, the US and other wealthy international powers (including China) will need to fund the remainder. As the immediate neighbor and proximate beneficiary (and with Ukraine seeking to become an EU member in due course following a peace deal), it is likely that the EU will need to fund the lion’s share of Ukraine’s reconstruction – perhaps as much as 70% or €700 billion.

European Inflation and Bond Markets

Like other developed economies, Europe is currently in the middle of an inflation shock caused by previous rounds of Covid stimulus and a tight labor market, and this has been exacerbated by the Ukraine war. The latest core inflation print for the eurozone remains elevated at5.5% year on year as of the end of June.

While the European Central Bank’s (ECB)’s restrictive monetary policy (+400 basis points of hikes in under 12 months) is likely to grind inflation back towards the 2% target over the coming 12-18 months, this might barely have been achieved just as the eurozone faces its next great inflation shock: the enormous cost of taking on the bulk of Ukraine’s reconstruction cost.

Assuming €100bn in annual reconstruction costs for Europe, with half funded by the private sector and half by Brussels, the €50bn increase in annual cost would equate to a c.30% increase in EU budget spending – a sizeable fiscal expansion.

Germany’s reunification highlights how German inflation in the late 1980s and early 1990s rose from close to 0% to +5% with interest rates remaining elevated into the middle of the decade. Furthermore, the Bundesbank tightened monetary conditions very sharply, achieving positive real rates of +2-3% (in contrast to where real rates are in the eurozone today).

With the need to fund Ukraine’s reconstruction, the eurozone could emerge as an inflationary outlier compared with other parts of the developed world over the course of the remainder of this decade. This view, however, is not priced in by bond markets, with eurozone yield curves remaining among the lowest in the developed world. As the prospects of a peace deal, Ukrainian reconstruction, European majority funding and persistently elevated eurozone inflation become clearer over the coming quarters, European bond markets could gradually begin to reprice the risk of higher persistent inflation for the remainder of this decade.

Investment Opportunities

With higher inflation risks in Europe, we believe the ECB will need to remain hawkish and long-term real interest rates will need to move into positive territory as they have in the US. We believe there is merit in being short many of the eurozone sovereign curves, particularly at the front end where yields remain deeply negative in real terms.

If our outlook scenario for higher long-term eurozone inflation plays out owing to high fiscal spend on reconstruction (significant resources mobilized from western to eastern Europe/Ukraine), ECB policy will need to remain restrictive and rate differentials would favor the euro versus other major G10 currencies as other developed economies restore inflation and policy rates towards more neutral levels.

In the early 1990s German reunification precedent, the Deutschmark appreciated +40% versus the US dollar as the Bundesbank was in tightening mode while the Federal Reserve was cutting.

Equity sectors where we would be inclined to hunt for opportunities include the obvious beneficiaries of physical reconstruction: construction, building materials, industrials and utilities.

Source: Macrobond, 6 July, 2023

Source: Macrobond, 6 July, 2023

Source: Macrobond, 6 July, 2023

[1] Source: World Bank/European Commission/ UN estimate as of February 24, 2023 is US$411bn (€383bn) https://www.worldbank.org/en/news/press-release/2023/03/23/updated-ukraine-recovery-and-reconstruction-needs-assessment

Ukraine’s government estimate is higher: estimated $750bn even before the end of 2022

https://www.dw.com/en/how-much-could-it-cost-to-rebuild-ukraine/a-63533638

We analyse what recent events in Russia could mean for the Ukraine war and Europe’s mid-term inflation outlook.

Key points

With Russia on the backfoot as Ukraine steps up its counter-offensive, Ukraine’s President Zelensky is incentivised to push to regain as much territory as possible over the coming weeks.
However, with US elections in 2024 and US military aid to Ukraine already costing $60bn, President Biden will be keen to show his electorate some progress and avoid another American ‘forever war’.
Although there may well be more bloodshed in the weeks and months ahead, we anticipate that peace negotiations may commence in the coming months.
We believe it is likely that the European Union will need to fund the lion’s share of Ukraine’s reconstruction – perhaps as much as 70% or €700bn.
Equity sectors we believe could benefit opportunities include the obvious beneficiaries of physical reconstruction: construction, building materials, industrials and utilities.

In this blog, we explain why we believe the Wagner Group’s mutiny and early-stage coup on 23-24June could be a potential gamechanger for the war in Ukraine. Although Wagner stepped down just 200km from Moscow in a deal brokered by Belarus’s President Lukashenko, Russian President Vladimir Putin’s leadership and scope for strategic flexibility appears to have been compromised.

Earlier timeline for a peace deal

With Russia on the backfoot as Ukraine steps up its counter-offensive, Ukraine’s President Zelensky is incentivised to push to regain as much territory as possible over the coming weeks, and thus we believe it extremely unlikely that Ukraine will accept a peace offer in the first instance. The US and its NATO allies will also want to push for Ukraine’s maximum territorial reclaim and possibly test the stability of Putin’s regime.

Avoiding a ‘forever war’

This does not preclude the prospect of extremely violent and bloody warfare in the next few months as Ukraine and NATO push for maximum advantage. What the Wagner insurrection has done is to shift the Russian calculus in favour of an early peace deal in order to minimise domestic damage. This appears likely to mark a significant strategic shift from the prior focus on playing the long-game war of attrition.

Rebuilding Ukraine

Any peace negotiations will be centered on three key issues: defence guarantees for Ukraine, the territorial limits of either side (including demilitarised zone), and how the reconstruction of Ukraine will be financed. We examine these factors below:

The reconstruction of Ukraine including its physical and social infrastructure is likely to cost up to €1 trillion[1] (for context, eurozone GDP is c. €15 trillion) over five to 10 years, or some US$100-200bn per year.
This could prove a conservative estimate; the reunification of Germany cost an estimated €2 trillion over 20 years, but East Germany was not a war zone with 8 million+ people displaced. The total population of East Germany in 1990 was 16.1 million. Furthermore, the €2 trillion. reunification cost was nominal. At inflated 2023 prices, this cost would be much higher.
There has been recent debate in European Union (EU) circles as to whether Russia’s seized international reserves could be used to help fund the reconstruction. The latest sentiment by EU leaders appears skewed against doing this on legal grounds, and because of potential international repercussions for the euro if foreign-exchange reserve holders begin to de-risk euro exposure as a consequence.
Despite these reservations, our view is that any peace deal with Russia will still be likely to feature a role for its confiscated international reserves. A reasonable assumption would be that 50% or c.US$150bn could be requisitioned to help finance the reconstruction of Ukraine.
Europe, the US and other wealthy international powers (including China) will need to fund the remainder. As the immediate neighbour and proximate beneficiary (and with Ukraine seeking to become an EU member in due course following a peace deal), it is likely that the EU will need to fund the lion’s share of Ukraine’s reconstruction – perhaps as much as 70% or €700bn.

European inflation and bond markets

Like other developed economies, Europe is currently in the middle of an inflation shock caused by previous rounds of Covid stimulus and a tight labour market, and this has been exacerbated by the Ukraine war. The latest core inflation print for the eurozone remains elevated at5.5% year on year as of the end of June.

Investment opportunities

If our outlook scenario for higher long-term eurozone inflation plays out owing to high fiscal spend on reconstruction (significant resources mobilised from western to eastern Europe/Ukraine), ECB policy will need to remain restrictive and rate differentials would favour the euro versus other major G10 currencies as other developed economies restore inflation and policy rates towards more neutral levels.

In the early 1990s German reunification precedent, the Deutschmark appreciated +40% versus the US dollar as the Bundesbank was in tightening mode while the Federal Reserve was cutting.

Equity sectors where we would be inclined to hunt for opportunities include the obvious beneficiaries of physical reconstruction: construction, building materials, industrials and utilities.

Source: Macrobond, 6 July 2023

Source: Macrobond, 6 July 2023

Source: Macrobond, 6 July 2023

[1] Source: World Bank/European Commission/ UN estimate as of 24 February 2023 is US$411bn (€383bn) https://www.worldbank.org/en/news/press-release/2023/03/23/updated-ukraine-recovery-and-reconstruction-needs-assessment

Ukraine’s government estimate is higher: estimated $750bn even before the end of 2022

https://www.dw.com/en/how-much-could-it-cost-to-rebuild-ukraine/a-63533638

How the theme of ‘great power competition’ could shape the macroeconomic backdrop in 2023 and beyond.

Key points

The impact on global markets of Russia’s invasion of Ukraine has been felt most manifestly in the form of even higher inflationary pressures (which were already elevated after Covid supply-chain and labour-market disruptions).
We expect to see a continuation of significant supply-chain realignments which are now showing up in the foreign direct-investment data for certain countries in the Asia Pacific region and North America.
We anticipate that China will pursue a more intense form of state-led economic development in the years to come and we believe the risks of (further) policy missteps are consequently higher.
As industrial economies increasingly turn to renewables and new-energy substitutes in the years ahead, competitive advantage is likely to be greatly defined by who has access to key material inputs including battery materials, composites, rare earths and precious metals.
While the US dollar will continue to benefit from its safe-haven status at certain points of heightened volatility in 2023, we expect to see non-democratic alliance countries increasingly seeking to diversify away from the dollar.
It is likely that post Covid, China will double down on its efforts towards manufacturing its own effective semiconductors and make convergence with the West a national effort.
The decade ahead could see a substantial increase in defence spending by democratic countries, with global defence spending expected to double by 2030.
In our view, global defence stocks should remain an attractive place to invest. Furthermore, many companies involved in defence and space technology may also prosper.

Last year will be remembered as one of the most geopolitically significant years in a generation – a year in which a major power staged a land invasion, occupation and annexation of another European country for the first time since World War Two. Most political analysts did not believe such an event could happen and that peace in our time would prevail. The ensuing fallout has been profound for markets given the disruption to commodity supply chains and the political repercussions for Russia, which has been disconnected from the Western economic system. The impact on global markets has been felt most manifestly in the form of even higher inflationary pressures (which were already elevated after Covid supply-chain and labour-market disruptions, coupled with two years of excessive monetary and fiscal stimulus by Western governments).

Central banks and governments in most developing economies, by contrast, had demonstrated far more conservatism and moderation. If inflation was to be the economic fallout from the Ukraine war, one of the principal political fallouts emerged in the shape of China’s reluctance to condemn Russia for its actions. In fact, with Russia’s invasion coming merely four days after the Beijing Winter Olympics ended, it appeared to most observers that President Xi had explicitly endorsed Russia’s actions. Although the relationship of the two powers is undoubtedly closer following the event, China’s response has been one of caution and trepidation about providing explicit support to Russia for fear of inviting secondary sanctions.

Autocrats versus democrats

Russia’s belligerence towards Ukraine made it considerably easier for President Biden’s US administration to push its global liberal and human-rights agenda, deepening several alliance relationships in 2022. The North Atlantic Treaty Organization (NATO) accepted Finland and Sweden as new pending members. In the Indo-Pacific, security relationships strengthened further with the Quadrilateral Dialogue countries[1] holding their first heads-of-state meeting in Tokyo in May. These developments, coupled with the financial and economic sanctions placed on Russia, led to a sense of deep unease by the so-called autocratic sphere. It remains too early to declare a new global schism along democratic-autocratic lines as between communism and democracy during the Cold War, but 2022 has certainly laid the foundations for continuing ideological drift.

Erstwhile US House Speaker Nancy Pelosi’s visit to Taiwan in August was a major political statement and test of China’s resolve. The US maintains that ‘strategic ambiguity’ is its official policy towards Taiwan and continues to officially uphold the One China Policy. Pelosi’s visit and other comments by the White House in support of Taiwan’s security put into question both notions. Geopolitical attention will remain strongly centred on Taiwan in the years to come because it sits directly at the nexus of national interest for the two great powers, China and the US. The likelihood of China attacking or blockading Taiwan has increased owing to events this year, but in our view remains a relatively low-anchored probability. In 2023 and beyond, the outcome is most likely to hinge on the extent to which Washington and the Taipei government are prepared to test and stretch the limits of China’s red line, including continuing military assistance, formalised trade agreements and the push for independence.

China experienced a very different 2022 from that which many anticipated, owing to its strict adherence to a zero-Covid policy and the enormous headwinds emanating from its real-estate sector. China’s 20th Party Congress, which took place in October, was the most important political event of its calendar, and the outcome was even more extreme in terms of President Xi’s consolidation of power than most experts had forecast. It means that China is likely to pursue a more intense form of state-led economic development in the years to come, and we believe the risks of (further) policy missteps are consequently higher.

Trade war

Last year was characterised by continuing trade conflict and the first signs of significant supply-chain realignments which are now showing up in the foreign direct-investment data for certain countries in the Asia Pacific region and North America. Financial markets have anticipated such realignment since the US administration first targeted Chinese trade in 2018 with c.US$300bn worth of tariffs, but the Covid pandemic provided an interlude, and China turned out to be a major beneficiary of the pandemic disruptions. Under the Biden administration, US trade measures taken against China are evolving and no longer merely take the form of arbitrary tariffs applied by the Commerce and Treasury Departments. Above and beyond this, the US Congress is now actively legislating and discriminating against Chinese trade with new laws such as the Uyghur Forced Labor Protection Act, the CHIPS and Sciences Act and the Inflation Reduction Act (IRA). These new laws restrict market access and channel significant amounts of subsidies towards US-based companies at the expense of Chinese (and in some cases European) manufacturing.

With no clear change in the course of US-China relations, an increasing number of Western companies are beginning to accelerate their ‘China+1’ supply-chain strategies. Vietnam, India, Indonesia and, to a lesser degree, Mexico all saw an acceleration in foreign direct investment during 2022. We expect these countries will continue to benefit disproportionately from the unfolding supply-chain realignments. US onshoring of high-end manufacturing will also be a major theme to watch in 2023, and with the extreme tightness of the US labour market that we have seen in recent years, high levels of industrial automation are likely to be an important accompanying investment theme.

Resource competition

The ‘other’ and more rapidly developing trade war that few had anticipated at the start of 2022 of course played out between Russia and the European Union (EU), principally in energy and commodities. After Germany terminated the Nord Stream 2 gas project in response to Russia’s Ukraine invasion, Russia slowed and then fully cut off supplies of natural gas through the Nord Stream 1 pipeline, leaving Europe scrambling to find alternative energy substitutes, with Germany raising its energy supply alert to level 2, encouraging voluntary demand curtailments from industry and households.

The outlook for global oil supplies also remains uncertain, as EU sanctions on Russian seaborne oil exports came into force in early December with a $60 per barrel purchase price cap for exemption, which Russian President Vladimir Putin has declared will not be honoured. With this latest measure there is a risk of exacerbating a twin energy crisis. While energy prices are likely to remain heavily volatile, driven by demand and seasonal factors, we believe it is geopolitics and the ‘weaponisation’ of both supply and demand that will keep energy prices elevated in the years to come.

Resource competition goes well beyond energy, however. As industrial economies increasingly turn to renewables and new-energy substitutes in the years ahead, competitive advantage is likely to be greatly defined by who has access to key material inputs including battery materials, composites, rare earths and precious metals. China has around a decade’s head start in securing these supplies across Latin America, Africa and the Asia-Pacific region. Given the scramble for critical resources to feed the latest green industrial revolution that we expect to play out over the next few years, it was noteworthy that Canada recently terminated three lithium licences held by a Chinese company. More intense resource competition in the years to come is likely to mean that democratic countries will seek to protect their assets for their own companies. Meanwhile, increasing levels of material processing (to date largely the preserve of China) will need to be built out within developed countries.

Tech war: how will China respond?

Technology has emerged as the principal domain through which the US seeks to contain China’s economic and military ascendency, with semiconductors the key enabler of tech. In 2022, the Biden administration tightened semiconductor restrictions on China, effectively preventing any US company, or any third country that uses US technology, from supplying semiconductors to China that have a speed of less than 14 nanometres. This blanket restriction is a significant escalation from the targeted restrictions that were previously in place on specific Chinese companies. To continue to promote the US’s own semiconductor industry, the administration has established a ‘CHIPS 4’ alliance comprising the US, Japan, Taiwan and South Korea. Although this has not been formalised, it is expected that these countries will now cooperate more closely on high-end semiconductor developments. To enhance the US’s own semiconductor national security, the passage of the aforementioned CHIPS and Sciences Act provides US$52bn of subsidy support to companies prepared to make investments in the US. Taiwanese semiconductor manufacturer TSMC’s recent pledge to bolster its US capital expenditure to US$40bn in the coming years is clear testament to the functioning of the new act.

Can China close the semiconductor ‘gap’?

The big question now is how China responds in 2023 and beyond, and whether its tech fate has been sealed. It should be emphasised that the vast majority of consumer and industrial applications can operate on semiconductors with 14+ nanometre speeds, which China will still have international access to. However, the country will need to develop its own capability to produce more advanced semiconductors. China’s semiconductor gap to the West looks unassailable but China is assembling huge domestic resources, including subsidies and a c.US$50bn public-private investment fund, along with scientific institutes and universities, to develop its own semiconductor industry. It is likely that post Covid, China will double down on its efforts toward manufacturing its own effective semiconductors and make convergence with the West a national effort. We believe that it remains too early to write off China’s domestic semiconductor industry, and that investors that do so may miss out on valuable opportunities.

Finance war

Despite the US dollar’s long-term broad international dominance and hegemonic currency status, Russia’s invasion of Ukraine truly underlined the degree of geopolitical leverage the status of the dollar and corresponding control of the international financial system gives to the US. The US government was able to freeze approximately half of Russia’s foreign exchange reserves (c.US$300bn) that it held outside the country, while access to the SWIFT international payment system was suspended for most of Russia’s banks. Russia was even prevented from making periodic coupon payments on its international sovereign debt, which led to a technical hard-currency debt default. Many observers may consider the above events a routine economic response to an act of military aggression. For many autocratic regimes around the world that are heavily dependent on dollar payments and assets, however, geopolitical leverage of the dollar and Western financial system is a sharp wakeup call. The geopolitical implications in the years to come are likely to be profound.

In our view, investors should not confuse the cyclical with the structural, and the dollar is likely to enjoy periods of safe-haven support in 2023 during periods of heightened geopolitical volatility. In the medium term, however, there is little question that non-democratic alliance countries, which fear falling foul of Washington, will seek to diversify away from the dollar. Data from central banks and the World Gold Council highlights the significant extent to which such regimes have already been increasing their holdings of physical gold in recent years, and many continue to add to gold reserves.

China has reduced its exposure to US Treasury bonds since 2015 by around 30%. Initial efforts were undertaken this year by some commodity exporters to price a portion of their oil sales in the local currencies of their customers, including Saudi Arabia selling in Chinese renminbi and Russia selling in Indian rupees. While this process remains nascent and the dollar remains the dominant pricing mechanism for most trade, the trends are becoming clearer. One thing that macro investors should watch for in 2023 and the years beyond is the effective rollout of central-bank digital currencies (CBDCs) by some of the larger countries, which would allow for instantaneous (and dollar-bypassing) trade clearing.

Security competition

Historians will look back on 2022 as the year that triggered regime change for military posture and consequently for defence spending. Most policymakers entered the year working under ‘liberal peace theory’ assumptions that had prevailed for the last 30 years. Few, if any, will have ended the year attached to the same assumptions: trade and investment interlinkages with a geopolitical competitor are no longer a guarantee of peace. Similarly, outsourcing defence and national security entirely to the US is no longer an option that can be fully relied upon.

The democratic alliance is likely to continue to forge ever closer relationships around security. We anticipate that recently formed alliances such as the Quadrilateral Dialogue and AUKUS[2] will continue to blossom, while Sweden and Finland’s application to join NATO is a further example of enhanced defence cooperation catalysed by drastic circumstances. However, we believe the major consequence of the events of 2022 is that the decade ahead should see a substantial increase in defence spending by democratic countries, with global defence spending very likely to double by 2030, outgrowing global GDP growth by a factor of two or three times. Immediately after Russia’s Ukraine invasion, the German government set up a one-off special defence fund of €100bn and pledged to increase annual defence spending to the level of 2% GDP (in line with the NATO target) from around 1.4% in 2020. Other European countries such as Italy that continue to lag this threshold are also set to raise spending.

At the other end of Eurasia, Japan has been unsettled this year by events around Taiwan and continued sabre rattling by North Korea. At the very end of 2022, this resulted in Japan’s government pledging a doubling of defence spending to 2% of GDP by 2027 and attaining a pre-emptive strike capability for the first time in its post-war history. For investors in 2023 and beyond, this means that global defence stocks could remain an attractive place to invest. Furthermore, as a large portion of the incremental spending will be directed to areas of defence technology and space, many companies involved in these areas may prosper.

Investment conclusions

It is no exaggeration to proclaim that 2022 has been a year of seismic geopolitical disruption which will be felt by investment markets for multiple years. While events themselves are usually impossible to predict, the good news is that having a robust thematic research framework in place can help investors to be more systematic about capturing opportunities and avoiding risks that arise from their fallout. In deciding how to allocate capital to navigate the geopolitical environment in 2023, we believe the following non-consensus views could have value:

Play defence in macro and micro: Geopolitical and macro caution could generally prevail in 2023. Despite a weak start to 2023, the US dollar could see renewed support as a safe-haven currency at certain points in 2023. Great powers may remain skittish and nervous of their adversaries. Security dilemmas are likely to persist, and thus defence spending could grow strongly and the defence sector should remain attractive for investors.

China bouncing back: China has been on the back foot dealing with real-estate and zero-Covid lockdown challenges in 2022. In 2023, particularly during the second half of the year, the government should have more capacity to turn its attention to domestic technology development to counter challenges from US restrictions. It should become increasingly possible for investors to identify who the domestic champions are set to be.

Global supply-chain realignment: Big government may grow bigger and broader in scope. Nowhere is this likely to apply more than Europe, which needs to respond to both energy crises and state-subsidy competitiveness challenges laid down by the US. We anticipate a large EU subsidy package for local manufacturing, electric vehicles and renewables, possibly around mid-2023. Provided EU inflation is on a normalising path, we believe that European equities should perform strongly at this point.

[1] US, Japan, India, Australia

[2] A trilateral security pact between Australia, the UK and the US.

We examine how the Russian leader’s actions have affected the market’s risk premium and what might happen next.

Key Points

Russia invaded Ukraine on February 24, but geopolitical risk around the event had been increasing since late 2021 when Russia began amassing troops on Ukraine’s border.

European (and global) inflation was rising ahead of the invasion, and headline consumer price inflation (CPI) had already broken out above the 2% range by mid-2021. However, Russia’s invasion and subsequent energy weaponization has undoubtedly exacerbated the inflationary backdrop.

Across the market, we see many areas of heightened risk premium, across equities, fixed income, currencies and commodities.

Other driving forces of risk such as central-bank tightening are also at play, but in attempting to quantify Russian President Vladimir Putin’s impact on risk markets, we believe he has contributed significantly to the 3% rise in market-risk premiums.

Faced with mounting losses on the battlefield, should the Russian president’s latest gambit to sow discontent in Europe by cutting off its winter-energy supply fail, his hold on power might be severely compromised by next spring.

Should such a scenario play out, a recovery in the euro/dollar exchange rate, a compression of European sovereign and credit spreads, and a price-to-earnings multiple rerating for European equities would all be in play.

Russia invaded Ukraine on February 24, but geopolitical risk around the event had been increasing since late 2021 as Russia gradually mobilized up to 180,000 forces on Ukraine’s border. European (and global) inflation was rising ahead of the invasion, and headline consumer price inflation (CPI) had already broken out above its 2% range by mid-2021. However, Russia’s invasion and subsequent energy weaponization has undoubtedly exacerbated the inflationary backdrop.

We have seen German inflation expectations (5-year breakevens) rise from under 2% prior to the invasion to above 3%, while across the market we see many areas of heightened risk premium, be it in equities, fixed income, currencies or commodities. Other driving forces of risk, such as central-bank tightening are also at play, but in attempting to quantify Russian President Vladimir Putin’s impact on risk markets we believe he has significantly contributed to the 3% rise in market-risk premiums.

Market Evidence

Examining market evidence to quantify this estimated Putin-related risk-premium rise, German 10-year bund yields (the anchor of European sovereign and corporate funding costs) were still below 0% at the start of the year and are now at 2.3% (as of October 9). Italy’s equivalent 10-year sovereign-bond yield has risen from 1% to 4.7% (+3.7%) over the same time frame. This is significant because Italy is generally regarded as the bellwether for European financial stability, given its very high debt-to-GDP ratio. European corporate high-yield spreads are around 300 basis points higher than they were at the time of Russia’s Ukraine invasion and the high-yield issuance market has practically dried up.

In equities, the Stoxx Europe 600 one-year forward price-to-earnings ratio has fallen from 15x just prior to invasion to slightly above 10x today; deconstructing the Gordon Growth Model,[1] we estimate that this level of derating would be consistent with a rise in the cost of equity of between 200 and 300 basis points. Meanwhile, the euro/US dollar exchange rate has fallen by 15% since the invasion. Currency changes are driven by a range of factors, but one very important one is a country’s terms of trade and changes to its trade balance; since the onset of Russia’s aggression, the eurozone’s current account balance to GDP has deteriorated by around 3%.

In commodities markets, Brent Crude oil prices have risen from around US$80 a barrel on the eve of the invasion to around $100 a barrel today, and were as high as $120 a barrel over the summer. Although the extended Organization of the Petroleum Exporting Countries group (OPEC+) has been restoring pre-Covid levels of supply for much of this year, its latest October meeting took the decision to reduce quotas by two million barrels per day from November, angering the US administration. Russia’s influence in OPEC+ should not be underestimated, and Russia’s energy minister, Alexander Novak, recently hinted that Russia’s supply could fall by around a further one million barrels per day once Western sanctions are imposed at the end of this year. This cumulative three million barrels of curtailed supply would equate to around 3% of global oil production.

What If Putin Exits or Concedes?

Political history teaches us that autocratic regimes exhibit high levels of non-permanence, but market volatility around regime change can be high (especially where it involves a regime with the world’s largest nuclear arsenal). Vladimir Putin has been in power since 2000 and the widely perceived view is that most Russians are now significantly worse off, both in terms of political freedom and economically.

Significant military setbacks in Ukraine as the West continues to pour military resources into the country, ‘partial mobilization’ including the calling up of 300,000 reservists, and recent evidence that Putin’s diplomatic sponsors are cooling towards the war, all appear to point to the Russian president’s back being against the wall. If Putin’s last gambit – attempting to freeze Europe into division and economic collapse over the winter by cutting off natural-gas supplies – fails to succeed, the springtime could prove politically decisive for Putin if Ukraine continues to make strong military gains.

Support for Putin from the political-security elite, the ‘siloviki’, could potentially evaporate. Putin could, of course, resort to the use of tactical nuclear weapons on the battlefield, a move that could undoubtedly slow down the Ukrainian advance. However, this could ultimately prove to be destructive for both Putin and his regime as moral support both domestically and from diplomatic allies would be likely to disappear completely.

With this scenario a reasonable possibility, should investors be beginning to think about what a post-Putin world could look like, and what type of regime might follow? While tail risks are quite ‘fat’ at both ends of the possible outcome distribution, we believe that the events of recent weeks have quite significantly increased the probability that Putin is either no longer at the helm in 12 months’ time or that he is forced to make concessions to end the war and begin a process of peace with Europe. If such a chain of events were to unfold, we believe that Mr. ‘three per cent’ Putin would hand back much of this risk premium to European (and to a lesser extent global) markets in short order.

If this scenario becomes reality, a recovery in the euro/dollar foreign exchange rate, a compression of European sovereign and credit spreads and a price to earnings multiple rerating for European equities would all be in play. In our view, investors should keep this possibility in mind, even as Europe’s macro pain seems set to worsen over the coming winter months.

Data We Believe Corroborates Putin’s 3% Impact on the Market-Risk Premium

Eurozone CPI was already at 5% on the eve of Putin’s Ukraine invasion, but war in Europe has undoubtedly exacerbated inflationary conditions, while German 10-year bund yields (the anchor of European funding costs) were still close to zero on the eve of the invasion. Since then, they have risen more than +200 basis points.

German 10-Year Bund Yields

Source: Bloomberg, Newton Investment Management, October 2022

Price-to-earnings multiples of European stocks have fallen four turns, consistent with a +200-300bps increase in European equity cost of capital. Meanwhile, Europe’s current-account balance (goods and services) as a percentage of GDP has fallen by around 3% since the onset of hostilities (latest publicly available data to June 2022) and European high-yield credit spreads rose from 3% on the eve of Russia’s invasion, to more than 6%.

European High-Yield Credit Spreads

Source: Bloomberg, October 2022

[1] The Gordon Growth Model is a theoretical formula that uses dividends, growth rate and cost of equity to calculate a stock or equity market’s fair value. Implied cost of equity can be deduced from the other factors in the formula.

We examine how the Russian leader’s actions have affected the market’s risk premium and what might happen next.

Key points

Russia invaded Ukraine on 24 February, but geopolitical risk around the event had been increasing since late 2021 when Russia began amassing troops on Ukraine’s border.

European (and global) inflation was rising ahead of the invasion, and headline consumer price inflation (CPI) had already broken out above the 2% range by mid-2021. However, Russia’s invasion and subsequent energy weaponisation has undoubtedly exacerbated the inflationary backdrop.

Across the market, we see many areas of heightened risk premium, across equities, fixed income, currencies and commodities.

Other driving forces of risk such as central-bank tightening are also at play, but in attempting to quantify Russian President Vladimir Putin’s impact on risk markets, we believe he has contributed significantly to the 3% rise in market-risk premiums.

Faced with mounting losses on the battlefield, should the Russian president’s latest gambit to sow discontent in Europe by cutting off its winter-energy supply fail, his hold on power might be severely compromised by next spring.

Should such a scenario play out, a recovery in the euro/dollar exchange rate, a compression of European sovereign and credit spreads, and a price-to-earnings multiple rerating for European equities would all be in play.

Russia invaded Ukraine on 24 February, but geopolitical risk around the event had been increasing since late 2021 as Russia gradually mobilised up to 180,000 forces on Ukraine’s border. European (and global) inflation was rising ahead of the invasion, and headline consumer price inflation (CPI) had already broken out above its 2% range by mid-2021. However, Russia’s invasion and subsequent energy weaponisation has undoubtedly exacerbated the inflationary backdrop.

Market evidence

Examining market evidence to quantify this estimated Putin-related risk-premium rise, German 10-year bund yields (the anchor of European sovereign and corporate funding costs) were still below 0% at the start of the year and are now at 2.3% (as of 9 October). Italy’s equivalent 10-year sovereign-bond yield has risen from 1% to 4.7% (+3.7%) over the same time frame. This is significant because Italy is generally regarded as the bellwether for European financial stability, given its very high debt-to-GDP ratio. European corporate high-yield spreads are around 300 basis points higher than they were at the time of Russia’s Ukraine invasion and the high-yield issuance market has practically dried up.

What if Putin exits or concedes?

Significant military setbacks in Ukraine as the West continues to pour military resources into the country, ‘partial mobilisation’ including the calling up of 300,000 reservists, and recent evidence that Putin’s diplomatic sponsors are cooling towards the war, all appear to point to the Russian president’s back being against the wall. If Putin’s last gambit – attempting to freeze Europe into division and economic collapse over the winter by cutting off natural-gas supplies – fails to succeed, the springtime could prove politically decisive for Putin if Ukraine continues to make strong military gains.

With this scenario a reasonable possibility, should investors be beginning to think about what a post-Putin world could look like, and what type of regime might follow? While tail risks are quite ‘fat’ at both ends of the possible outcome distribution, we believe that the events of recent weeks have quite significantly increased the probability that Putin is either no longer at the helm in 12 months’ time or that he is forced to make concessions to end the war and begin a process of peace with Europe. If such a chain of events were to unfold, we believe that Mr ‘three per cent’ Putin would hand back much of this risk premium to European (and to a lesser extent global) markets in short order.

Data that we believe corroborates Putin’s 3% impact on the market-risk premium

German 10-year bund yields

Source: Bloomberg, Newton Investment Management, October 2022

European high-yield credit spreads

Source: Bloomberg, October 2022

We examine how the theme of divergence is creating opportunities for global bond investors in the US market.

By Paul Brain

Key Themes

We are seeing global bond investment opportunities arising from the concept of divergence.
The negative impact of the Ukraine conflict is coming through in terms of weaker growth and higher energy and food prices, especially in Europe.
The US is significantly more self-sufficient in energy and food than Europe so there are likely to be some US beneficiaries of higher energy and food prices.
The gap between US and European interest rates should stay wide over the near and medium term.
We believe there are opportunities to start building exposure to three-year US Treasuries and to US investment-grade credit securities.

As bond investors with a global remit, a lot of the themes currently interesting to us are heavily influenced by the concept of divergence as different areas of the world take different approaches to monetary and fiscal policy to deal with their respective economies.

We have just been through a period where policy looked similar in most places. Following the global financial crisis, most central banks converged towards a zero level of interest rates, and this has involved various forms of quantitative easing (QE) which effectively dampened down yields across the curve.

Diverging Responses

Now though, we are moving in the opposite direction, and responses to the various concerns about inflation and the economy are coming through in different ways. Since the Covid crisis we have seen a lot more fiscal stimulus in addition to monetary intervention, and the contrast in policy between the US and European economies has become quite marked.

Europe has taken a more ‘socialist’ approach to supporting struggling sectors than the US; in particular, with the Ukraine conflict contributing to an energy and food crisis as the world recovers from the pandemic, European governments are providing subsidies to those sectors and individuals struggling with higher energy and food costs.

While higher prices are likely to have a negative impact on growth in Europe, the US finds itself in quite a different position. It is significantly more self-sufficient in energy and food than Europe so there are likely to be a number of US beneficiaries of higher prices.

As a result, the US economy is in stronger shape: US consumers were already in a good position because of the wealth effect that has been filtering through from a reduction in debt and increasing saving levels, while the US corporate sector is also in a stronger position than its European counterparts.

Different Responses, Different Time Horizons

We are seeing this reality play out through differing central-bank policy decisions. The US Federal Reserve (Fed) is looking to raise rates rapidly because it needs to choke off inflation expectations, whereas the European Central Bank (ECB) is expected to take a more measured approach, as it is starting from a much lower base and, in some cases, negative interest rates. At the same time, the Fed is also quickly reducing its balance sheet, either by not reinvesting sales proceeds or ultimately through selling bonds back into the market – another form of monetary tightening. In Europe we are seeing a little of this, but at nowhere near the same speed or magnitude as in the US.

With governments fiscally stimulating in different ways and central banks operating in different ways, the net result is that bond and currency markets are likely to respond differently over different time horizons. This means that the gap between US and European interest rates is likely to stay wide, as should the gap between US and Japanese interest rates, as Japan does not face the same inflationary pressures and thus the authorities are able to maintain a deflationary mindset.

As global bond investors, we believe these divergent trends offer some attractive opportunities. Divergence means that we can invest in one market, and perhaps short another to balance that risk in an environment that we expect to remain quite volatile for some time.

US Rate Rises Already Priced In

The opportunities in the US are coming from the idea that, because the Fed has been so vocal about the possibility of raising rates, the market has already priced that scenario in. Therefore, we are seeing opportunities to start building exposure to three-year US Treasuries and to US investment-grade credit securities where we can seek to gain additional yield from widened spreads on companies that we view as relatively safe in terms of their ability to service the coupon and pay the principal back. Buying those types of bonds and locking in that yield over the next two to three years seems an attractive option for flexible bond investors currently.

We can’t say the same in Europe where yields are not as attractive (having not risen as much). We expect this scenario to continue for some time, as the ECB gets into its stride in raising interest rates. On top of that, the negative impact of the Ukraine conflict is coming through in terms of weaker growth and higher energy and food prices. This is leading to less demand and less investment compared to what we are currently seeing in the US.

From a credit perspective, we therefore favor the US over Europe, where we believe companies will remain more challenged in terms of the overall cost of doing business over the next couple of years.

We examine how the theme of divergence is creating opportunities for global bond investors in the US market.

Key themes

We are seeing global bond investment opportunities arising from the concept of divergence.
The negative impact of the Ukraine conflict is coming through in terms of weaker growth and higher energy and food prices, especially in Europe.
The US is significantly more self-sufficient in energy and food than Europe so there are likely to be some US beneficiaries of higher energy and food prices.
The gap between US and European interest rates should stay wide over the near and medium term.
We believe there are opportunities to start building exposure to three-year US Treasuries and to US investment-grade credit securities.

Diverging responses

Different responses, different time horizons

We are seeing this reality play out through differing central-bank policy decisions. The US Federal Reserve (Fed) is looking to raise rates rapidly because it needs to choke off inflation expectations, whereas the European Central Bank (ECB) is expected to take a more measured approach, as it is starting from a much lower base and, in some cases, negative interest rates. At the same time, the Fed is also quickly reducing its balance sheet, either by not reinvesting sale proceeds or ultimately through selling bonds back into the market – another form of monetary tightening. In Europe we are seeing a little of this, but at nowhere near the same speed or magnitude as in the US.

With governments fiscally stimulating in different ways and central banks operating in different ways, the net result is that bond and currency markets will respond differently over different time horizons. This means that the gap between US and European interest rates is likely to stay wide, as should the gap between US and Japanese interest rates, as Japan does not face the same inflationary pressures and thus the authorities are able to maintain a deflationary mindset.

US rate rises already priced in

From a credit perspective, we therefore favour the US over Europe, where we believe companies will remain more challenged in terms of the overall cost of doing business over the next couple of years.

The investment communications team’s Matthew Goodburn asks senior geopolitical strategist Richard Bullock how the Ukraine conflict is changing the dynamics of China and Russia’s relationship and what the implications could be for international relations and investment markets.

This podcast was recorded on 21 April 2022.

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This podcast was recorded on 21 April 2022.