Will Ukraine prove to be the catalyst for another crisis?

Yes

Steen Jakobsen

Chief Investment Officer, Saxo Bank

Steen Jakobsen, Saxo Bank

The former US Secretary of State Henry Kissinger once said: “Diplomacy is the art of restraining power.” If that is the case then diplomacy as conducted by the EU and US is failing and miserably so, setting up a big outlier risk for the world economy and markets. How these outliers pan out is almost impossible to predict, but it is important to realise that everyone loses with this conflict, no one more than Russia.

Russia’s economy was already in free fall before the situation escalated. I visited Russia in late January and was surprised to find the mood among investors and CEOs at 1997/98-low levels. Russia’s GDP growth will have a hard time staying on the right side of zero for the year. This corresponds to more than 5 per cent growth pre-financial crisis. Their current account surplus peaked in the mid-2000s at 10 per cent of GDP; this year they will barely break even. Vladimir Putin’s popularity was at an all time low going into the conflict. Now he makes Russians proud, at least according to the polls.

Russia is clearly misunderstood. No scholars or pundits seem able to understand Russia’s viewpoint and put it into a historical context. History tells us how Russia will proceed. A friend of mine put it best: “To deal with Russia and Putin is like playing poker with a robot. It does not know how to blink, leaving no tells.”

All this is concerning but the biggest negative from the crisis is much higher energy prices and a desperate rush to fill the energy production gap which we have created through failed green energy investment and by closing down nuclear power generation. The Ukrainian situation will only make this worse.

Europe is energy deficient. EU dependency on imports is increasing for all fossil fuels. Oil imports reached 83.5 per cent in 2009 and 64.2 per cent for gas, according to the EU Commission.

The April 2011 Fukushima earthquake was a terrible event, but the decision taken by many European countries to close down nuclear power stations could be the biggest strategic mistake since the energy crisis in the 1970s and its consequences will be elevated energy prices stretching into the future.

Moving towards green energy is a noble objective and a correct one over the long term as we have finite fossil resources, but if you run a structural deficit in terms of energy generation then the last thing you want to do is stop your own ability to produce. This goes full circle to the Ukraine-Russia situation.

The Ukraine crisis will go on for much longer than anyone wants, everyone will lose and world growth will disappoint again, but the real issue behind the scenes is Europe’s lack of a coherent energy policy. The present green energy policy is a mess. Green energy is inefficient, tax burdening and nowhere near close to meeting rising energy demand from Europe.

The biggest loser will be Germany. There are more than 6,200 German companies engaged in business with Russia. The Economist states that 300,000 German jobs are at risk, German business investment into Russia exceeds €30bn, excluding financing from German banks, but more importantly Germany imports 70 per cent of its energy of which 25 per cent comes from Russia. Angela Merkel and her government have been caught out by a failed energy policy, which has made electricity a luxury good for many German households. But even worse, she decided that she would rather be dependent on Mr Putin than on nuclear power.

The biggest consequence of the Ukraine conflict could be a revisiting of the 1970s energy crisis, including energy rationing. After close to 30 years of doing this job I am realising that energy is everything in explaining growth, investment, sentiment and market returns.

Understand energy and its marginal price of production and its delivery and you have the keys to predicting the world. Sadly Europe and the US is stuck in using Sir David Frost’s definition of diplomacy: “Diplomacy is the art of letting somebody else have your way.”   

No

Mark Burgess

CIO, Threadneedle Investments

Mark Burgess, Threadneedle

While investors and commentators keep a watchful eye on Ukraine, financial markets are largely focused elsewhere. Sanctions are hitting the Russian economy, and Europe may face repercussions particularly regarding energy availability. However as things currently stand, the probability of a worst case scenario materialising in Ukraine would have to significantly increase before a pronounced impact on global financial markets is felt.

The crisis first hit investors’ radar in February this year, taking a short-lived toll on emerging market debt and equities, as well as commodities. As it continued to unfold, Russia’s equity market fell on escalation of the tensions with Ukraine and the annexation of the Crimean peninsula. This market bore the brunt of the fallout, as reactions elsewhere in financial markets remained relatively muted.

There is scope for the crisis to escalate further, particularly if it comes to a military stand-off or trade war between the West and Russia. But the stakes involved today pale in comparison with those of a generation ago. In this conflict, it seems that capital flows – not tanks or planes – are the West’s strongest weapon. The US recently outlined the clearest picture yet of the next phase of economic sanctions, contemplating penalties on Russia’s defence, high technology, engineering and energy sectors.

The Russian economy is being hit by the unrest and the sanctions already imposed on its companies and individuals. Capital fled the country at a record pace in the first quarter, the $50.6bn (€37bn) nearly equalling the total amount of last year. Yet with 25 per cent of Russian companies’ debt coming from non-domestic lenders, their dependence on international capital markets is higher than ever.

The consequences of sanctions are not just confined to Russia. Due to economic links with the country, the European economy faces bigger repercussions than the US. Around 30 per cent of Europe’s natural gas supply comes from Russia, half of that piped through Ukraine. Any move to curb Russian oil exports could easily drive Brent crude oil into the $140-160 a barrel range and unnerve investors. The situation remains fluid, yet markets seem to consider the risk of the worst case scenario – a direct armed confrontation in Ukraine – as fairly remote.

Instead, investors are taking their cue from elsewhere. Some emerging market equities have rallied, taking encouragement from Janet Yellen’s speech in March and her indication that interest rates would remain low for the foreseeable future. Political factors also played a role. Brazil, Turkey and India are holding elections this year and their stockmarkets have surged on the back of hopes for an improved political environment. Narendra Modi and his BJP party have won a resounding victory in the Indian elections, while a pro-market president is likely to take the helm in Indonesia in July. We remain cautious on China, however, where the consequences of a credit-fuelled bubble are only just beginning to show.

Emerging market debt rallied in recent weeks upon the increase in interest rates by a number of emerging central banks. Commodities are up 9.6 per cent this year and in the eurozone, the bond yields of the once struggling governments have fallen to record lows, indicating that investors’ concerns over the region have evaporated.

We continue to watch the situation in Ukraine closely, but as it stands today financial markets are focused elsewhere.