Russia/Ukraine – Russia is being cut-off.
The war between Ukraine and Russia has escalated. Russian local markets finally opened this week, with prices reflecting a default in sovereign debt and almost no value in Russian equities. Despite two rounds of negotiations, there has been almost no progress on a cease fire agreement given the large gap in demands between both sides. Even agreement on a corridor to allow civilians to flee Ukraine seems to have failed. We see this development as a negative as it signals further escalation rather than de-escalation.
The two key questions for markets going forward are will NATO get involved in the war and will Russia default on its debt? On the former, NATO has been supplying arms to Ukraine but has stopped short of direct assistance. We expect this to remain the case, though the risk is rising of NATO involvement given growing political pressure from voters. This risk is currently not priced in the market and would be a very negative event. On the latter, firstly, Russia’s willingness to continue to honour external debt is declining: Putin had said he would honour external debt last week but a decree over the weekend ordered for all USD payments to be paid out in Ruble instead. Secondly, and more importantly, Russia’s ability to pay is declining fast. In addition to the high cost of the war (estimated between $3-20bn daily), it’s unlikely that Russia will regain access to foreign capital markets in the medium term, making it pointless for them to continue honouring debt at the risk of depleting accessible foreign reserves (Russia cannot access around 2/3rds of their foreign reserves due to sanctions). We therefore expect Russian sovereign debt to default.
ECB Ahead – Won’t give us the clarity on policy we’re looking for.
This week’s ECB meeting is likely to show a delay of tightening this year, as European policymakers are caught off-guard by the war in Ukraine and will be hesitant to make final decisions before a resolution is in sight. Decisions could include leaving asset purchases open-ended at €40bn per month, and emphasizing language to do whatever it takes to support the economic rebound. At the same time, we’ll see new staff forecasts on inflation and growth, likely featuring large upward revisions for inflation in 2022 and already including the impact from the war.
Downside risks to growth in the Eurozone mean that the ECB doesn’t want to impose additional stress to the system by withdrawing liquidity now. Inflation however, is rallying on as last week’s prints of 5.8% headline and 2.7% core came in once again ahead of expectation, and oil now trades above $120. Further, long-term inflation expectations have rallied almost 0.5% since 23rd February, as EUR 5y5y inflation swaps now price 2.2%. Absent of the war, this mix would certainly warrant a hawkish pivot, as the ECB’s three conditions for rate hikes are now clearly met. However, rates markets are torn between pricing the hiking path and risk-off price action, and Morgan Stanley estimated that last Tuesdays violent duration rally washed out 85% of shorts from the first 6-8 weeks of the year, leaving positioning now much cleaner.
We believe a delay in tightening this week is sensible, but will ultimately put the ECB even more behind the curve of fighting inflation. Any delay in hikes this year should therefore be priced for 2023, with upside risks to more and faster hikes needed once the war is resolved.
Algebris Investments’ Global Credit Team
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