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By Templeton Global Equity Group
Initial Views on the Situation
Russian President Vladimir Putin has unleashed a multi-front invasion of Ukraine, removing the possibility of a small-scale operation limited to just the eastern regions that were officially recognised by Moscow last week. It is unclear whether Russia intends to absorb Ukraine or to install a puppet government and run Ukraine as a vassal state; however, historically, Kyiv was an important cultural center for Russia and what has become clear is that Russia intends to regain control of the capital. This is a very aggressive act drawing strong rebuke and condemnation from the West, and therefore continued escalation is likely and part of our current base-case scenario.
Ukraine is not a NATO member and we do not anticipate US ground troops in the country at this time, but the possible knock-on effects from this event are myriad. Most immediately, the conflict could have implications for European borders and the regional geopolitical order for years to come, likely elevating the equity risk premium across these markets.
The degree of the impact largely depends on the Western response, which in turn depends on the severity and duration of the conflict itself. A swift coup that results in a quick de-escalation will likely see the West’s response limited to economic sanctions. However, a protracted and bloody occupation could see Russia become a pariah state in the eyes of the international community, possibly resulting in counter-insurgency measures by Ukrainian allies, among them NATO members. This is a scenario that no one wishes for, and which would devastate financial markets, but is not currently our base-case assumption.
The extent to which Russia’s actions embolden other authoritarian regimes with extraterritorial ambitions also remains to be seen. Investors are watching China’s response closely given its views on Taiwan, while also monitoring developments among oil-producing nations like Iran, which has been subject to Western sanctions, but could be called upon to help fill the void created by restricted Russian supply. The implications are far-reaching and the situation is highly dynamic, but ultimately we believe Putin has miscalculated. What began as an attempt to opportunistically leverage the pro-Moscow rebel movement in Ukraine to extract concessions has actually just brought the United States and Europe in closer accord on their mutual response and condemnation, adding to Russia’s long-term strategic complications.
From a broader macro perspective, we expect increasingly severe and stringent sanctions from the West, and a response from Russia that will likely involve curbing oil and gas exports. This conflict should keep upward pressure on commodity prices (not just energy commodities, but agricultural products as well), though the rest of the world does have some levers to pull to help increase supply of key commodities should elevated prices continue to meaningfully impact consumer spending and broader economic conditions.
Despite continued and significant inflationary pressures, the adverse impact of this conflict on global financial conditions could delay expectations of interest rate hikes by key central banks. For example, prospects for a 50 basis-point increase in the federal funds target rate in March have diminished, though markets are still pricing in a 25 basis-point hike. We could also see a delay in the European Central Bank’s anticipated path to less expansionary, and ultimately tighter, financial conditions. The need for rising rates to combat inflation has not changed, but the unhealthy reliance of markets on easy monetary conditions may cap the full extent of monetary tightening justified by economic conditions. Furthermore, recent events could potentially impact the timing of rate increases.
Strategy Implications
We have not found attractive opportunities in Russian equities given heightened corporate governance concerns and geopolitical risks. While we do not have any direct exposure to Russian companies that could be impacted by such sanctions, the broader market selloff is creating volatility in all risk assets. We are not currently making any major changes to our strategic positioning, though portfolio managers continue to make adjustments designed to take advantage of volatility and manage evolving risks.
The reason that we do such in-depth fundamental research at the company level at Templeton is to ascertain the true long-term value of an enterprise and to be able to act confidently when that value changes or markets overshoot their estimation of it. While we do not anticipate major strategic changes, the situation is very fluid, and we are monitoring it closely and prepared to act as necessary.
Markets were already contending with heightened global geopolitical tensions, lower long-term growth expectations and structurally higher interest rates and inflation. The Russia-Ukraine conflict makes these already-negative issues for global financial markets all that much worse. However, these same structural macro shifts are also playing a role in how investors think about value.
Slower growth and higher interest rates have sharpened investors’ focus on fundamentals, shifting priorities from a top-line growth mindset to more of a focus on the sustainability of earnings and cashflow. While the near-term impact of kinetic war in Europe will surely be negative for financial markets, it also accelerates the move away from the low interest rate, low inflation, benign economic environment that favoured expensive growth stocks in the past cycle. This transition has benefitted Templeton’s strategies and, near-term uncertainty aside, we believe that the broader macro environment will continue to trend in this direction.
As a result, we believe opportunities will continue to emerge for long-term investors focused on quality and fundamentals. While that is potentially positive for our strategies over the long run, we recognise that in the short term this is a highly uncertain event likely to result in significant volatility and periods of indiscriminate selling. More importantly, it is a humanitarian disaster, and we hope with all sincerity that the actors in this conflict will find some way to a swift resolution that minimises human suffering.
Our hearts go out to the innocent people of both Russia and Ukraine who simply wish for peace.
What Are the Risks?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
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