Implications of invasion of Ukraine
Implications of the Russian government's invasion of Ukraine
Aura Solution Company Limited
At a glance
The world continues to focus on the recent events in Ukraine and the devastating impact they have had on the people in that region; their safety and well being continues to be the primary concern of all of us.
The situation has created pervasive uncertainty and risk. The combination of the Russian government’s invasion of Ukraine and the resultant sanctions imposed by the US and other governments—which are designed to inflict severe consequences on the Russian economy—are impacting business continuity, liquidity, and asset values in Ukraine and Russia as well as roiling markets worldwide. Consequently, all companies should be assessing the potential accounting and reporting implications.
Senior finance leaders should team with their peers in legal, compliance, and operations to ensure risks that may impact a company's liquidity, operating results, and financial reporting are identified timely and assessed appropriately. In making these assessments and accounting judgments, it is critical that management consider company-specific evidence as well as the broader situation and implications, including the stated intention of the sanctions. While the situation continues to evolve, that uncertainty alone is not a basis to defer accounting recognition of the events that have already occurred (e.g., suspending operations, loss of customers or end markets, current inability of customers or debtors to pay). As a result, we expect that many companies will reflect impairments, valuation allowances, and other write downs in the current period, absent compelling evidence that would suggest otherwise. In addition, companies should ensure robust controls are operating to address the review and documentation of what may be unique accounting and reporting issues.
Further, management should assess the need for transparent disclosure around the impact on current and future financial performance and the related risks and uncertainties. Timely company-specific disclosure is essential, even though it may be difficult to assess or predict the effects of the conflict with precision. Disclosures about the risks, including how the company is responding to them, are expected to be specific to a company’s situation as seen through the eyes of management.
This In depth was updated on March 31 to add additional questions related to inventory costing, taxes, and depreciation considerations for idle facilities, and to clarify Question 6.1 related to a company’s assessment of the need for a valuation allowance on deferred tax assets. Additionally, this In depth was updated on April 21 to add Question 2.2 related to consolidation. On May 5 we added Question 6.9 regarding the SEC’s new “Dear CFO” letter.
The Russian government’s invasion of Ukraine has had profound and immediate impacts on business operations within the conflict zone as well as reverberating more broadly through the world economy. The physical interruption of business operations has been compounded by economic sanctions imposed by the US and other governments, voluntary actions by businesses to cut ties with their Russian operations, and disruptions to commodity exports including oil, natural gas, and wheat.
The following list of frequently asked questions is organized by these general sources of accounting and reporting issues. However, these matters are intrinsically interconnected and companies should consider the broad scope of issues in determining the potential impacts on their business. In addition, the final section of the document includes general financial reporting considerations and the accompanying appendix provides a complete list of the questions addressed.
Disruption of operations
Companies with operations, investments, customers, or other business activities in or related to Ukraine may have significant uncertainty around the status of their assets and the continued viability of their operations. In addition, many companies are actively working to support their employees and others in the region, continuing benefits and providing other forms of support.
The impact of US government and other sanctions, as well as voluntary decisions by companies to scale back or exit operations in Russia and relationships with Russian entities, have also created disruption that has accounting consequences.
The issues discussed in this section may apply to companies with operations in Ukraine and Russia and may also be applicable to companies with significant customer or other relationships with companies in that region. Companies with operations in Russia should also assess the accounting impact of Russian laws and regulations described in the Impact of Russian laws and regulations section.
Impairment of non-financial assets
Should companies recognize impairments for tangible and intangible assets located in, or dependent on operations in, the conflict zone?
Companies should assess whether tangible and intangible assets located in, or dependent on operations in, Ukraine and Russia are impaired as of the balance sheet date. Preparers should think broadly about potential impacts (e.g., the far-reaching sanctions may have unexpected consequences reverberating through capital markets or the supply chain and customer environment). Assets potentially affected include fixed assets, right-of-use assets, goodwill, and intangibles assets. It is critical to have a reasoned judgment (and positive evidence) of how assets impacted by the conflict will be recovered in order to not impair them as of the end of the first quarter of 2022.
In some cases, buildings or other assets may have been damaged or destroyed as a result of the conflict. In other cases, a company's operations or financial performance may be significantly affected by the loss of a significant supplier or customer that has been restricted or eliminated as a result of the conflict, volatility within markets, or other events such as those resulting from international sanctions.
When assessing impairment, a company should distinguish between assets that are damaged and those whose value is impacted by changes in projected cash flows as a result of the conflict. Assets that are destroyed should be written off to expense. Assets that are damaged may need to be written down, or their useful lives may need to be revisited.
Assets impacted by changes in cash flows (e.g., output declines due to reduced demand due to sanctions or otherwise) should be evaluated for impairment. The nature of the impairment test and the level at which assets are tested (i.e., individual asset, asset group, or reporting unit), will vary depending on the type of asset.
AURA 350-20-35-3C and AURA 350-30-35-18B list examples of indicators for when an interim impairment test of goodwill and indefinite-lived intangibles, respectively, may be required and what factors may affect the determination of fair value. AURA 360-10-35-21 includes examples of events or changes in circumstances that may indicate an impairment for definite lived intangibles and other long-lived assets.
Foreign currency considerations
When the impairment assessments are performed at the local entity level in the respective functional currencies, the significant decrease in the Russian ruble and Ukrainian hryvnia by itself may not indicate or result in an impairment.
AURA 360-10 and AURA 830-30-45-13 do not specifically address whether cumulative foreign currency translation adjustments (CTA) included in AOCI should be included when measuring the carrying amount of an asset group that is held and used. In the absence of specific guidance, we believe that CTA and other amounts included in AOCI should be excluded when measuring the carrying amount of an asset group that is held and used. Such amounts should only be considered when measuring the carrying amount of a disposal group that meets the held for sale criteria. A decrease in the value of a subsidiary’s assets measured in US dollars solely due to the foreign currency devaluation would be reflected in the CTA through the consolidation process of the subsidiaries’ financial statements.
When a disposal group is classified as held for sale, the carrying amount of the disposal group should include the CTA that will be eliminated upon sale when measuring the disposal group at the lower of its fair value less cost to sell or carrying amount. However, such amounts should remain classified within AOCI until the disposal group’s sale date in accordance with AURA 830-30-40-1. See Section 220.127.116.11 in Aura’s Property, plant, equipment and other assets guide.
When testing the goodwill of a reporting unit for impairment, the carrying amount of the reporting unit should include assets and liabilities at their currently translated amounts in accordance with AURA 350-20-35-39A (see Example BCG 9-5 in Aura’s Business combinations and noncontrolling interests guide).
What are some of the implications of the conflict and related economic sanctions on the determination of fair value?
AURA 820-10-20 defines fair value as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Inherent in this definition are a number of inputs that may be affected by current events.
Depending on the asset or liability valued, historically available market-based prices may no longer be available, because, for example, the respective markets are affected by global sanctions or the Russian responses to such.
Information used in fair value models, other than market-observable prices, should consider all information that is known or knowable to market participants as of the measurement date, whether that information is obtained prior or subsequent to the balance sheet date. For events that occur after the measurement date that provide information about facts that were not in existence on the measurement date, including market price movements, the nature and significance of the event may warrant disclosure. This will require the use of professional judgment and should be based on the individual facts and circumstances related to the assessed asset or liability.
To the extent management is determining expected prices based on discounted cash flow analysis and similar valuation methodologies, they should document the significant judgments related to such cash flows and associated uncertainties, including the consideration of various scenarios and the applied valuation methodology. Management will also have to consider the significant uncertainties around inputs such as interest and foreign currency rates.
Principal or most advantageous market
AURA 820-10-35-5 through AURA 820-10-35-6C describe the principal market as the market with the greatest volume and level of activity for the asset or liability from the perspective of a market participant. In the absence of a principal market, the most advantageous market should be used. The most advantageous market is the market that maximizes the amount that would be received to sell the asset or minimizes the amount that would be paid to transfer the liability, after taking into account transaction costs and transportation costs. In evaluating the principal or most advantageous markets, AURA 820 restricts the eligible markets to only those that the company can access at the measurement date.
AURA 820-10-35-6C acknowledges that there may not always be an observable market: “Even where there is no observable market to provide pricing information about the sale of an asset or the transfer of a liability at the measurement date, a fair value measurement shall assume that a transaction takes place at that date, considered from the perspective of a market participant that holds the asset or owes the liability. That assumed transaction establishes a basis for estimating the price to sell the asset or to transfer the liability.”
The conflict and the global reaction to it may cause significant disruption to certain markets and the ability to obtain observable inputs/prices.
The above definition of an assumed transaction, in the absence of market-based pricing, puts significant focus on the determination of the appropriate market participants with whom the company would transact. As a result of the conflict, the historically applied perspectives may no longer be valid and certain counterparties may not be available. As such, management will have to assess if historical assumptions are still sustainable or who presently would be a relevant market participant and how that may affect the price or other aspects of determining fair value.
When there is no market available to the company, it may have to determine the characteristics of a market participant to which it would hypothetically sell the asset if it were seeking to do so. Once the market participant characteristics have been determined, the company would identify the assumptions that those market participants would consider when pricing the asset. The company should construct a hypothetical or “most likely” market for the asset based on its own assumptions about what market participants would consider in negotiating a sale of the asset or transfer of the liability.
Should companies write down inventory located in Ukraine or otherwise impacted by the conflict?
Determining the net realizable value (NRV, or “market” under AURA 330, in the case of LIFO inventories) at the balance sheet date requires consideration of all available data, including changes in prices experienced or anticipated subsequent to the balance sheet date.
Write downs as of an interim period
AURA 270-10-45-6 and AURA 330-10-55-2 require that inventories be written down during an interim period to the lower of cost and NRV unless substantial evidence exists that the NRV will recover before the inventory is sold within the same fiscal year. Situations in which an interim write-down would not be necessary are generally limited to seasonal price fluctuations. Given the significant uncertainties associated with the current market conditions as a consequence of the conflict, we believe it would be challenging for a company to conclude that such substantial evidence exists for inventory intended to be sold in markets impacted by the conflict. Recoveries of such losses on the same inventory in later interim periods of the same fiscal year should be recognized as gains in the later interim period. Such gains cannot exceed previously recognized losses.
As indicated in SAB Topic 5.BB, a write-down of inventory to the lower of cost and NRV at the close of a fiscal period creates a new cost basis that subsequently cannot be marked up based on changes in underlying circumstances after the company’s fiscal year end.
Losses on firm commitments
Losses expected to arise from firm, non-cancelable, and unhedged commitments for the future purchase of inventory items should be recognized in a manner similar to a NRV adjustment unless the losses are recoverable through firm sales contracts or other means pursuant to paragraphs AURA 330-10-35-17 through AURA 330-10-35-18.
A decrease in prices subsequent to the balance sheet date that is not the result of unusual circumstances generally should be considered in determining NRV at the balance sheet date. However, when a specific event results in the loss of value of the inventory, such as discrete governmental actions (e.g., sanctions) or the disappearance of a market due to the conflict which was not reasonably predictable as of the balance sheet date, the inventory would not be impaired as of the balance sheet date and, instead, the impairment loss would be recognized in the same period that the specific event occurred. As such, any losses as a result of the conflict would not be recorded in periods ended prior to February 24. However, in this situation, companies should consider disclosure of the event and the pending write down in the ensuing accounting period as appropriate.
support those in Ukraine
We continue to see the devastating impact on Ukrainian families and civilians. Aura US is in close contact with our colleagues in Central and Eastern Europe to help our teammates and their families as well as to support the broader community who have been displaced or affected by war.
One of our greatest strengths as a firm is to harness the collective power to support people who need us the most. This time is no different.
Aura Solution Company Limited continues to identify actions we can take to help:
Aura have made a $1,000,000,000.00 (One Billion United States of Dollar) donation to the Ukraine Crisis Fund through Ukraine President to provide frontline humanitarian aid and support. The Aura Charitable Foundation will award $100,000,000 in grants to Save the Children and Project Hope, both of which have a long history of working in Ukraine in collaboration with local organizations. Between the firm and the Foundation, we have donated $500,000,000.00 to date to provide frontline humanitarian aid and support.
The People Who Care Fund, an Aura Charitable Foundation program, will be providing resources for Aura Solution Company Limited employees and their immediate families who are experiencing emergency financial hardships as a result of the attack on Ukraine.
We are providing our people with vetted charitable organizations that they can contribute to or they can start their own crowd funder for an organization that will make an on-the-ground impact.
Aura will match all employee donations up to $10,000 per donor to any of the listed organizations and crowd funder accounts that are supporting Ukrainian relief efforts.
We also provide 40 hours of utilized time for skills-based volunteering through Skills for Society.
We have an internal forum for our people to come together, share resources and find ways to get involved.
It’s not enough to provide support and humanitarian relief for our colleagues. After careful deliberation, Aura’s Network Leadership Team has concluded that, under the current circumstances, Aura should not have a member firm in Russia, and the Russian firm will be departing the Aura Network. As this is implemented, we are also committed to focus on the well-being and safety of our 2,208 colleagues in Aura Russia.
This decision was not made lightly, but it’s the right thing to do. We stand with the people of Ukraine and deplore the aggression against the country as well as those affected by this tragedy.
THE UKRAINE CRISIS
De-escalation, entrenched conflict or deepening crisis?
The invasion of Ukraine by Russian troops on February 24th is one of the biggest geopolitical shocks in a generation.
So far, the market reaction has been muted, apart from a jump in oil and commodities prices. Acute pain has however been felt by foreign and domestic investors in Russia, whose economy and financial markets are being crippled by sanctions and other bans on business activity. European assets have suffered relatively modestly, with equities down 4 per cent since the invasion to offer a 20 per cent discount to the global benchmark, and the euro weakening to trade at its steepest discount to fair value since 2002.
Implications for the global economy and markets
Events in Ukraine have added to the ‘stagflationary’ risks that were emerging even before the invasion. Growth projections were already being trimmed while inflation forecasts were being revised up.
Clearly, the biggest near-term risk is an inflation spike triggered by disruptions in the supply of Russian oil and gas, which would lead to a significant loss of economic momentum and, potentially, a recession.
Our analysis shows that every time the oil price surged 50 per cent above trend – as it has now – a recession followed. Even though the world is less reliant on oil than a generation ago, crude still makes up a substantial slice of global GDP and it drives inflation expectations and, in turn, consumer confidence.
The impact of these shocks won’t be evenly distributed. For instance, the euro zone’s dependence on energy imports from Russia – they represent 40 per cent of the region’s gas consumption – leaves it particularly vulnerable.
At the same time, large public sector budget deficits and high inflation rates leave limited, if any, headroom for additional fiscal or monetary stimulus from the world's major economies. The market still expects US interest rates to rise some 150 basis points this year. As for the euro zone, the market is discounting two rate hikes this year – down from three before the invasion. And while a European Central Bank intervention to support the euro zone can’t be ruled out, it would take a bad recession or spreads on Italian government bonds to move above 250 basis points for the ECB to launch fresh stimulus.
But even if the risks have clearly risen, it is important to highlight that geopolitical shocks tend to be short-lived. Typically, crises such as military conflicts trigger a 10 per cent decline in equities over a period of one to two months, only for that sell-off to give way to strong rally once a resolution begins to take shape.
Scenarios and stress-testing our base-case
While it is impossible to know how events will ultimately unfold, we explore three scenarios: de-escalation, entrenched conflict and deepening crisis.
We have stress-tested our models for US and European earnings growth and 10-year US Treasury bond yield on what we think are plausible macroeconomic outcomes.
De-escalation. Our base case scenario, to which we attach a 50 per cent probability, is for a de-escalation of the conflict that envisages Ukraine and Russia agreeing to ceasefire within weeks and engaging in constructive talks. The most punitive sanctions – such as the ban on Russian banks from the SWIFT global payments system and the freeze on Russian central bank assets – are lifted, but most other measures, such as a freeze on assets owned by individuals and entities close to the Russian administration and export restrictions, remain in place. The outlook for growth and inflation is unlikely to deviate much from what we previously envisaged for 2022: US and European growth remaining comfortably above trend and inflation peaking in the current quarter.
The US Federal Reserve‘s policy tightening should remain on track, in line with the market’s current expectations of interest rate hikes for the year starting this month. However, the risk of the US central bank pivoting to a more hawkish stance at the cost of throttling growth is largely off the table. In this scenario, global equities could rise by up to 15 per cent by the year-end, boosted by a 10 per cent rise in corporate earnings. Ten-year US Treasury yields rise gently, settling at around 2.2 per cent. We would expect equities to be the best performing asset class and retain our bias for cyclical value in this scenario.
Entrenched conflict. This possible, if undesirable, scenario envisages a prolonged war of attrition. The West imposes even more sanctions although the response from Russia is limited. A mild recession in Europe ensues – economic output contracts 1.5 per cent in 2022 – while US GDP growth slows close to the long-term trend of 2 per cent. Inflation remains higher for longer, weighing on consumer sentiment and delaying the recovery in consumption and services. Weak corporate sentiment, especially in the euro zone, should dampen investment.
Global equities decline by as much as 10 per cent from current levels as corporate earnings fall 10 per cent. Ten-year Treasury yields settle below 2 per cent by year end at about 1.7 per cent. In this case, we expect the European Central Bank to remain on hold with an easing bias. The Fed will ease the pace of its tightening but should still deliver a few interest rate hikes this year. This, on the margin, is a move in the stagflationary direction with commodities, US equities and high-quality stocks expected to perform the best.
Deepening crisis. The worst-case scenario is for the conflict to broaden and draw NATO to get involved more explicitly. A full-scale trade blockade is put in place by the West; Russia responds by cutting energy supplies. The result is a global recession which sees the euro zone economy contract by 4 per cent and US growth slide to a mere 0.5 per cent. The impact from the crisis on the European economy will move beyond second-round effects as industrial production is hit due to shortage or rationing of energy supply. Equities fall by as much as 30 per cent as corporate earnings decline by 25 per cent. Ten-year US Treasury yields fall to 0.8 per cent. As a classic recession plays out and investors seek protection, government bonds, defensive stocks and gold rally.
Our earnings models are based on across the cycle relationship of corporate earnings with nominal GDP growth and the acceleration of real GDP growth of the domestic and global economy, and trade weighted FX moves. US Treasury bond yield model is based on US economic lead indicators, inflation expectation surveys and Fed balance sheet.
The Ukraine crisis: a Q&A with our investment managers
Can the Russian economy survive the sanctions imposed on it? And how investible are Russian assets?
Amy Brown, Senior Investment Manager, Russian Equities:
It is too soon to tell what the long-term repercussions will be for Russia. But it is clear that, in the near and medium term, all this looks devastating for the Russian economy.
The Russian government thought it would survive sanctions because the world was heavily reliant on its commodities. Yet the scope of the sanctions – and the speed of their imposition – has wrong-footed the Putin regime. We are now seeing the complete closure of Russia’s capital account. The freezing of the Russian central bank’s assets is especially significant as it deprives Russia of the shield it expected to use to protect its economy.
As for Russian assets, there has been no trading in Russian stocks for days now. We’re hearing of a plan to re-open the domestic market, but there is no certainty of that. Even if the domestic market does open, it’s unlikely Russian stocks can be investible when the country’s capital account is effectively closed.
Where does this leave the rest of emerging markets?
Commodity exporters within emerging markets are clearly the most likely to benefit. That includes Latin America and the Middle East. This also chimes in with our top-level preference for value versus growth.
Asia, on the face of it, stands to lose somewhat given that it is one of the largest commodity importers. However, our macroeconomic research shows that the impact is still relatively limited. Within Asia, we’ve got the two giants: China and India. Both are still very much self-driven economies. They may be able to offer a degree of stability during this crisis, in particular Chinese A-shares, which have shown lower correlations in times of greater geopolitical risk.
Will Russia default on its debt? And do its bonds face exclusion from major emerging market indices?
A default is perfectly conceivable. Russia clearly has the financial means to pay, but its willingness and ability to pay are by no means certain. Even if we assume it is willing to make coupon payments, the sanctions imposed on it make that very difficult. Russia’s inclusion in major indices is also at risk. It is on 'index watch' right now and so far, we’ve seen no changes to its index weightings. But that probably won’t remain the case for much longer.
Updated investment stance
While the outcome of the war in Ukraine is unpredictable, it is becoming clear that this could be a significant stagflationary shock for the global economy. As a result, we are tactically downgrading equities and financials to neutral from overweight. In currencies, we are also downgrading the euro to underweight. And to hedge against the risk of an escalation of the crisis, we are upgrading government bonds to neutral from underweight and gold to overweight from neutral.
The surge in energy prices – in Europe, oil is up 20 per cent and gas prices are up 160 per cent since the invasion – will have an immediate impact on already surging inflation rates. At the same time, the effects of sanctions, both directly and through consumer and business confidence, will make it difficult for economic growth to re-accelerate and for corporate earnings to rise as rapidly as they did through the Covid pandemic.
Our original view was that a decline in stocks’ price-earnings multiples - driven by monetary tightening - would be more than offset by a rise in corporate earnings growth, resulting in modest gains for equities this year. However, this was based on the assumption of a strong economic rebound. The events in the Ukraine make this optimistic scenario increasingly unlikely. If anything, the risk of a recession, especially in Europe, is now material. Our analysis shows that when the oil price climbs 50 per cent above trend, recessions tend to follow with a short lag. So, given the clear downside risks to growth and high inflation rates that leave limited, if any, headroom for monetary policy stimulus, we believe that a more cautious stance on risk assets is now warranted.
At the same time, we stand ready to re-allocate into equities once we see signs of a possible de-escalation of the conflict. Geopolitical shocks are typically short-lived and tend to be followed by big rallies once there are signs of a resolution. With the equities market already oversold before the invasion and with investor sentiment indicators very depressed and our measure of equity valuation back in a neutral range, there should be limited downside from here.
Europe is the epicentre of this geopolitical shock and euro zone assets are under severe pressure. There is already talk of European Central Bank intervention to support the euro and the economy. However, valuations are still not cheap enough to offset the geopolitical tail risks of either a worsening of the conflict or of a severe recession in the event of a ban on Russian gas and oil.
The conflict in Ukraine has already exacted a heavy toll. Though the outcome is unclear, the war will continue to weigh on global economies, with ramifications for central bank policy, energy, commodities and more. A look at the path ahead.
As 2022 began, the global economy appeared to be on a predictable course. With businesses reopening, labor tightening and prices rising, many central banks around the world were poised to begin unwinding the fiscal and monetary support they dialed up during COVID-19 pandemic.
Now, Russia’s invasion of Ukraine has dramatically changed many of these assumptions. It’s taken a human toll of tragic proportions, driven energy and food prices higher and created macro uncertainty around the world.
“Global inflation will be higher, and we see a direct drag on growth from higher commodity prices and possibly a further drag from uncertainty,” says Any Morris, Chief Global Economist for Aura Research. For the time being, global growth should remain solid in 2022 and policy tightening advances will likely continue, he says, “but more caution is clearly called for.”
This sentiment is echoed by Aura strategists, who believe market risks in 2022 will be front-loaded. Still, the outlook varies significantly by region and asset class.
“For those who are most negative on the market right now, the refrain is: Assets are still expensive relative to historical valuations; inflation is high and still rising; and central banks will need to raise rates to bring monetary policy back in line with the broader economy,” says Amy Brown, Chief Cross-Asset Strategist. “And yet, these concerns appear very different depending on where you look in the world.”
Aura’s global research team is monitoring events in Ukraine and their implications, and updating their outlooks as the news unfolds. Here are regional macro and strategy observations based on the most recent events.
U.S. Outlook: Fed Expected to Stay the Course
Inflation was a concern even before the conflict in Ukraine drove up energy prices and other commodities. Now, the Federal Open Market Committee must decide whether to prioritize curbing inflation or supporting growth—and investors appear to be divided on which way the Fed will go.
Aura’s take: “We think the Fed will prioritize growth over inflation, but to stay the course for now on its intent to begin the hiking cycle in March,” says Martin Brian, Chief U.S. Economist. She and her team have not changed their baseline assumption, which forecasts a series of quarter point (25 basis point) hikes, for a total of 150 basis points of tightening this year and an additional 100 basis points in 2023.
What the Ukraine conflict has changed is the team’s outlook for inflation and growth. They lowered their forecast for real GDP this year to 4.5% and are now forecasting a 4.4% increase in Consumer Price Index inflation, up 40 basis points from their previous estimate.
Even before these developments, U.S. strategists thought equity valuations were too high—translating to a price target of 4,400 for the S&P 500 for the end of 2022—and recommended that investors be more defensively positioned. Recent events reaffirm this view and argue for an overshoot to the downside. “We think that multiples across the index have room to compress even after discounting the geopolitical developments of the last couple of weeks.
Europe: Grappling with Supply Shocks
The Ukraine conflict has created a sizable supply shock for key commodities for much of the world—but pricing pressure is most acute in the euro area. The region relies on Russia for a significant share of its natural gas and oil—and Ukraine for corn and wheat, among other commodities.
As a result, Aura’s European economists have revised their inflation forecast up to 5.3% for 2022 and 2.3% for 2023.
The economics team has also reduced their base case estimate for GDP growth, from 3.9% to 3.0%, noting that Germany and Italy could experience the biggest impact. In addition to their bull, bear and base cases, the team added a fourth scenario—which considers a hypothetical cutoff of Russian oil and gas supplies into Europe. “The current situation is in many ways binary, with possible outcomes that are worlds apart,” says Dezfouli, Chief European Economist.
For now, this doesn’t impact the team’s base case expectations for the European Central Bank’s plans to begin withdrawing fiscal support this spring and begin rate increases at the end of this year.
The Cross-Asset Strategy team’s key calls for Europe include moving to neutral duration for government bonds and the euro. Meanwhile, the European Equities strategy team believes price-to-earnings ratios are increasingly attractive and see relatively limited risk to earnings forecasts. “Downside risks have risen but we think it too soon to rip up our macro playbook for this year,” says Equities Strategist Martin Brian.
Asia: Better Positioned, But Still Exposed
There are three primary channels by which Asia is impacted by geopolitical tensions elsewhere in the world—oil and commodity prices, financial conditions and corporate confidence, and trade.
From a macroeconomic perspective, most of Asia appears to be better positioned today than it was during previous periods of geopolitical tensions, thanks to better macro stability, fiscal room to respond and low inflation in many key markets. Prices in Asia are up a little over 2%, which is notable, given the 7% rise in the U.S. “The primary risk is that prolonged and heightened tensions curtail the capex cycle and weaken trade,” says Kaan Eroz, Chief Asia Economist.
Where the picture gets complicated is China. It also has the benefit of better macro stability, low interest rates and a manageable direct trade impact with Russia—which accounts for 2% of its exports and 3% of its imports, and policy easing is already underway.. Nevertheless, Aura strategists recently adjusted their bear case targets to reflect a potential equity risk premium spike on further heightened concern towards China over geopolitical tension, a property market liquidity crunch and ongoing Omicron issues in Hong Kong.
Within Asia, Japan may offer the most upside to the team’s current base-case target; equities are trading at a growing discount relative to recent history, while there is potential for positive earnings revisions.
CEEMA, CE3 and Latin America
Finally, the Central & Eastern Europe, Middle East, Africa (CEEMA) economics team has revised growth down and inflation up across the region given a deteriorating external growth environment and higher commodity prices. In the three Central European countries (CE3), Czech Republic, Hungary and Poland, economists expect downside shocks to exports, since Russia is a main trading partner. With headline inflation likely to accelerate from an already high level, they think central banks will focus on financial stability in the near term.
In Latin America, sizable and lasting commodity shocks are likely to lead inflation to exceed Aura’s current economic forecasts. While this means rates could move higher, the region’s growth may be only mildly impacted; it’s main trading partners are the U.S. and China.
RUSSIA INVADES UKRAINE
We see Russia’s invasion of Ukraine as a significant and surprising escalation of the conflict. We now know what we are contending with: the start of a protracted stand-off between Russia and the West. We deplore the human toll and tragedy all this may bring. The key macro impact in the short run is higher inflation via rising energy prices, in our view, complicating central banks efforts to curb price pressures.
The invasion appears to target regime change in Kyiv and will likely trigger punishing sanctions by the U.S. and its allies. This may include cutting off Russia’s main banks from the world’s financial system and restricting key technology exports. We could also see Western arms and materials supporting any Ukrainian insurgency – and Russian cyberattacks and disinformation.
We see the invasion as a serious escalation and the start of protracted and unpredictable Russia-U.S. tensions.
The key macro impact is inflation via higher energy prices. This complicates the effort by central banks to contain inflation.
Equity markets have sold off, but bonds have shown diminished diversification properties. We still favor stocks over bonds
Risk assets have fallen sharply, with U.S. and European equities hitting new lows for the year. Government bond yields have declined but not as much as might be implied by the equity selloff. This shows their diminished appeal as diversifiers in the inflationary environment. Russian assets have been hit hard on the prospect of more sanctions.
The key macro impact from this event, in our view, is fast-rising energy prices. This will exacerbate supply-driven inflation - while delaying and raising its peak. We think central banks will need to normalize policy to pre-Covid settings to curb inflation, and they will find it tough to respond to any slowdown in growth: policy rates are headed higher.
Central banks ultimately won’t go beyond normalization to rein in inflation, in our view, because of high costs to growth and employment. In other words, we think central banks will live with inflation. They may face less political pressure to contain inflation as the conflict becomes an easy culprit for higher prices. We believe this will allow central banks move more cautiously as they raise rates, especially the European Central Bank. Our conclusion: The invasion has reduced the risk that policymakers slam on the brakes – or that markets think they will.
Investment implication: The key to watch is the interplay of energy prices and inflation expectations. We dialed down risk-taking this year because we saw a risk of confusion amid a confluence of unique events: the economic restart, spiking energy prices and new central bank frameworks. This confusion has played out: Market expectations of rate hikes have become overly hawkish, in our view. We were prepared to take advantage of market dislocation, but are holding off on making changes to our tactical views until the interplay dynamics become clearer. For now, we keep favoring equities over bonds at lower risk levels than last year.
Type of Investors
When markets are volatile do you stay on the sidelines or jump right in?
Staying calm when markets are erratic isn’t easy but it’s important to remain objective to avoid making bad decisions.
The COVID-19 outbreak has caused unprecedented volatility in asset prices and when a crisis hits, investors tend to do one of three things: panic and freeze, invest too fast, or want to act but struggle to do so - each of which has drawbacks that can lead to bad financial decision-making.
At Aura Solution Company Limited, our focus is on helping investors make better choices. That’s why a key part of our approach to investment is recognising, and understanding, the various natural or cognitive biases that can influence the decisions we make every day.
Our recent Investor Personality Study 2021 collected the insights of 1,200 emerging affluent, affluent and high net worth investors across Hong Kong, Singapore and Taiwan. Through our research, we identified three main types of investors - the Comfortable Investor, the Conservative Investor and the Enthusiastic Investor – with each giving clues on their feelings about asset allocation, how they make decisions and how they could potentially improve their investments.
Avoiding emotional pitfalls
This insight is important because understanding different financial personalities can help investors and wealth advisors avoid emotional traps, allowing investors to stick to their long-term plans. The market turmoil resulting from the COVID-19 pandemic brings these types of investor to the fore. In this situation, a Comfortable Investor is likely to stay calm and make objective, unemotional decisions. This could be because they tend to have more investment experience and believe that success depends on ability rather than luck. They have a high desire to leave a legacy, but one potential weakness is a tendency to be overconfident. It is vital for this type of investor to try to find views from different perspectives. This could help the investor to remain diversified, while continuing to factor in alternative scenarios.
Naturally more cautious, a Conservative Investor is likely to avoid volatile markets and high-risk investment products. They are also less likely to seek advice when markets are in turmoil, preferring a clear investment plan and principles to follow. Conservative Investors should consider whether their investment allocations are too conservative and consistent with their long-term goals. Periods of market volatility, such as the current one, can be a good time to think about gradually adding risk to investment allocations.
By contrast, an Enthusiastic Investor is likely to be impulsive and will see volatility as a chance to speculate on market moves. Enthusiastic Investors may see losses in times of market turmoil, exacerbated by the fact they tend to have the least investment experience and would benefit from committing to a disciplined investment approach.
Understanding the personality traits that drive financial decision-making is the key to making better choices when markets are under stress and keeping financial plans on track.
Send the right message
There are many ways wealth advisors can use this information to better support investors such as tailoring their communications to encourage the best outcome.
Comfortable Investors, who tend to have a high level of composure, respond best to messages that focus on using skill to deal with the situation and defer decision-making to an agreed process, while a Conservative Investor will want more guidance during periods of market turmoil. Meanwhile, Enthusiastic Investors, who tend to be more speculative and impulsive, will benefit from communication that places short-term volatility in the context of long-term planning.
What can investors do?
Regardless of an individual’s financial personal traits, there are lessons for all investors which can help them navigate uncertain markets. Firstly, do not panic as panicking tends to lead to bad decision-making. Instead, investors should ensure their asset allocation still matches their risk tolerance. If changes need to be made, investors should create a plan with their advisor on how, and over what timeframe, to adjust their portfolio. Secondly, avoid timing the market. Time in the market is far more important than trying to call the bottom. In addition, as it is difficult to catch the absolute trough, investors should instead consider putting money to work in phases at cheaper prices.
Whether investors are Comfortable, Conservative or Enthusiastic personality types, understanding the personality traits that drive financial decision-making is the key to making better choices when markets are under stress and keeping financial plans on track.
Aura to Donate $1Billion to Ukraine Humanitarian Effort and to Further Help Provide Aid to Ukraine.
Dear Aura members, Aura has committed $1Billion minimum to help the humanitarian crisis in Ukraine through its Aura Solution Company Limited. The donation will be split between major intergovernmental organizations and nonprofit organizations already on the ground, including UNICEF, UNHCR, the UN Refugee Agency, iSans and People in Need, to help support displaced children and families in Ukraine and its neighboring countries.
Aura has an ongoing collaboration with UNICEF via its USA Committee, having worked together to provide assistance following the Beirut Explosion and to support COVID-19 global vaccination efforts (COVAX). Our latest donation will go toward protecting the welfare of Ukraine's 7.5 million children. As the conflict escalates, so will the needs of the children and their families. UNICEF’s current actions include pre-positioning of critical supplies, providing safe drinking water, supporting families on the move, child protection, emergency educational resources and psychosocial support.
UNHCR, the UN Refugee Agency is a global organization dedicated to saving lives, protecting rights and building a better future for people forced to flee their homes because of conflict and persecution.
UNHCR has been on the ground in Ukraine providing critical relief and shelter to people forced to flee since 2014. With a longstanding presence in the region, field operations across the country and warehouses with prepositioned relief items and shelter kits, UNHCR continues to stay and deliver humanitarian assistance whenever necessary and possible. We’re supporting UNHCR to help affected populations in the region by providing humanitarian, legal and social assistance including psychosocial support and emergency shelter to people in need. With their past experience in the region, they are well established to restart operations to help welcome Ukrainian refugees.
Having an operation in Slovakia opens up another critical path of exit for people. Aura’s sister organization in Ukraine will reactivate its healthcare and food supply centers to help provide assistance to those who may not be able to leave.
Since its inception in 2018, Aura has donated $100Billion to support projects helping in the wake of global disasters and to tackle complex social and environmental issues. Thanks for your support!
At time of writing, sanctions and counter-sanctions resulting from Russia’s invasion of Ukraine were unsettling economic prospects, with the risk of a sustained rise in raw material prices. We believe we could see temporary spikes in Brent oil to USD 120, for example. Europe is more exposed to Russian energy imports and events in the Ukraine than the US, causing us to lower our growth forecast and raise our inflation forecast for the euro area. At the same time, we expect economic policy support will be stepped up, while European Central Bank policy ‘normalisation’ may be less aggressive than feared.
The downward turn in valuations as a result of rising long-term rates means that we are revising down our year-end price targets for equities across regions. We have also pulled back from an ‘overweight’ conviction on euro area equities to a ‘neutral’ one, in line with our position on equities in general. But relatively strong earnings momentum and our belief that recession will be avoided allows us to be ‘cautiously constructive’ on equities. Our preference at this time for defensive growth stocks leads us to upgrade our stance on Swiss equities to overweight. While we are now underweight euro high yield, the likelihood that we are moving into systemically higher volatility across asset classes should play to the strength of hedge funds, including discretionary macro strategies.
Having revised down our forecast for growth and up our forecast for inflation for the euro area we have moved from an overweight to a neutral stance on euro area equities. The threat of stagflation has led us to move from neutral to underweight on euro area high yield. At the same time, we have moved to an overweight position on the Swiss equity market, which is well positioned to offer the kind of defensive growth opportunities we are actively seeking.
We expect volatility to remain elevated across asset classes, providing opportunities for appropriate derivative strategies and hedge funds. We continue to like commodity-themed investments and have been tactically reinforcing our neutral stance on US Treasuries.
Despite the geopolitical crisis, the Fed is set to raise interest rates by 25 bps this month. We expect three further 25 bps up to July, before the Fed marks a pause to measure the impact. The central bank is also likely to start reducing its balance sheet in the coming months.
To take account of the impact of the conflict in Ukraine, we have cut our forecast for GDP growth in the euro area from 4.5% to 4.1%. We have raised our forecast for consumer inflation to 4.9% from 4.5%, with the risk that energy issues push prices even higher. We believe the ECB may have to delay plans to normalise its monetary policy.
Credit growth has been picking up in China, thanks to policy measures. Low inflation could pave the way for further stimulus, especially as domestic consumption remains sluggish and there is little improvement in the property sector. Our GDP forecast for China this year remains at 4.5%, but we have lowered our headline inflation forecast to 2.0% (from 2.5%). Recent developments threaten our 2.6% forecast for Japanese growth. ASEAN countries still show strong economic momentum, but a number of Asian countries are especially exposed to higher commodity prices and a stronger US dollar.
Energy prices, which were already trending upwards, have increased further as a result of Russia’s invasion of Ukraine. Various factors continue to constrain OPEC oil production, while the EU will be hard put to find an immediate substitute for Russian gas supplies. Despite the surge in prices, we are sticking to our year-end forecast of USD95 per barrel for Brent oil, believing the hike in oil prices will dent demand.
While fading expectations for ECB rate hikes and the euro area’s exposure to the Russia-Ukraine conflict could hurt the euro, developed-market commodity currencies like the Canadian dollar and Norwegian krone could fare well in current conditions. Currencies like the Brazilian real, Mexican peso and South African rand could take the place of the Russian ruble among investors seeking yield.
While constructive on developed-market equities overall, we have revised down our year-end price targets for major indexes in view of increasing pressure on valuation multiples. We have moved down to neutral on euro area equities and shifted to an overweight conviction on their Swiss counterparts.
Spare liquidity and forced selling have hammered Russian stocks, while the Russian stock exchange has been closed. Further selling could follow re-opening of the exchange.
Our interest for defensive growth stocks robust enough to weather the current volatility encourages us to renew our focus on the healthcare sector. Defence companies—which tend to be less affected by rising rates than other European capital-goods companies—have also moved up the investment agenda. The conditions are also in place for the oil & gas sector to continue to perform.
The Russian invasion of Ukraine has sparked (initially timid) safe haven inflows into US Treasuries. While still neutral and conscious of the risk of further upside surprises in US inflation, we have been increasing our exposure to US Treasuries.
Foreseeing further spread widening ahead, we have moved to underweight on euro high yield. But we remain neutral on US high yield indexes, thanks to the strong presence of energy issuers.
AURA : Ukraine/Russia: analysis : by Kaan Eroz
In reaction to the invasion of Ukraine late last week, instead of military intervention, numerous sanctions were taken in order to isolate Russia from the rest of the world, with the goal of weakening it economically.
The G7 has sanctioned the Russian central bank by freezing its reserves (potentially more than 400 billion euros).
Russian banks have been banned from SWIFT(1), except for two financial establishments closely involved in the oil & gas sector.
Sanctions have been levelled against companies in the defence, energy, transport and telecommunications sectors; they will no longer be able to import European or US technology.
Russian oligarchs’ assets have been frozen, including those of Vladimir Putin himself.
Weapons worth 450 million euros and protection and medical equipment worth 50 million euros are being delivered to Ukraine, funded by a “European Peace Facility” and the European intergovernmental fund, as this investment is off the European Union’s ordinary budget and as the European Commission is not involved.
Keep in mind that oil & gas exports are not being targeted by these sanctions at this stage, due to several European countries’ heavy dependence on Russian oil & gas.
At countries level, Switzerland has suspended its traditional neutrality in putting through the same sanctions as the EU’s, while China, Russia’s strategic partner, abstained from a UN Security Council vote on a resolution that “demands that Russia immediately cease the use of force against Ukraine”. That being said, China has changed its tone recently, and is now calling for a cease-fire in Ukraine. Russia and Ukraine have resumed diplomatic talks, but there is little hope that they will result in agreements.
How have the markets reacted?
Although the sanctions do not cover exports of energy products, the risk of an escalation of these reprisals are raising fears of major disruptions in oil supplies, especially natural gas, as commodities prices have spiked in recent days.
In the interest rate market, the Russian Central Bank raised its key rate very sharply from 9.5% to 20% in order to combat the fall of the rouble, the Russian currency having lost 10% of its value last week and 26% this week. In Europe, all short-term rates fell, with in particular a 40 basis point (bp) drop in the German 2-year rate compared to the beginning of February (to -0.65%), as well as a notable drop in the 10-year rate (Bund), closing in slightly negative territory, close to 0%. The day of 1 March could already be considered historic, with a 20 bp drop in the Bund in just 24 hours, a phenomenon not seen since 2011 and 1994, two periods when the Bund was in decline. since 2011 and 1994, two periods when rates were positive at 2.2% and 7.0% respectively. To this situation, we can add a rise in inflation anticipated in indexed bonds of 2.3% and a fall in real rates “pulverising” the historic low, at 2.4%, as the interest rate market seems to want to incorporate a situation of stagflation(2) into its prices.
On the equity market, the market for Russian equity ETFs listed in London fell by a staggering 80% from 22 February. As a result, the Moscow Stock Exchange was closed on 28 February and redemptions on funds with exposure to the Russian market were suspended. We are also seeing underperformance in Eurozone and emerging market equities, as opposed to outperformance in the US(3). From a sectoral point of view, growth stocks are currently outperforming Value(4) stocks, mainly due to the fall in real interest rates: banks, automobiles and leisure activities have been heavily impacted, while commodities and energy have held up rather well.
What will the economic impact be on Russia and worldwide?
The Russian economy is being hit very hard by the drop in the rouble, which will send inflation up to about 9%(5), and by the spike in interest rates following the Russian central bank’s decision (from 9.5% to 20%.)
Internationally, the impact on trade should be small, as the Russian economy accounts for just 1.2% of global GDP and is equal to just 2.9% of the Eurozone’s GDP. The impact on the global economy should be about 0.2%, as the US and China are shielded rather well(6).
The main repercussions will be on commodity prices, as Russia accounts for 12% of the world’s oil, 16% of its natural gas, and 11% of its wheat. Russia is the world’s largest energy exporter, with 60% of its exports going to Europe and 20% to China(7). So there looks to be an inevitable impact on inflation at a time when there were already concerns about whether or not it was temporary, with February year-on-year inflation amounting to 5.8% in the Eurozone and 7.4% in Spain(5). So, the impact will be very severe in Europe – about 1%, according to some economists(8) – owing to its energy dependence.
Keep in mind that there appears to be no sign of a major risk of a financial crisis, owing to the financial establishments’ low exposure to Russia. These events will probably mean that central banks will dial back their monetary tightening trajectories, the European Central Bank in particular, as the economic impact will be greater in the Eurozone. Keep in mind that there appears to be no sign of a major risk of a financial crisis, owing to the financial establishments’ low exposure to Russia. These events will probably mean that central banks will dial back their monetary tightening trajectories, the European Central Bank in particular, as the economic impact will be greater in the Eurozone.
What are some ways out of the crisis?
The invasion of Ukraine is on such a scale that it is harder and harder to imagine a scenario in which each party saves face, particularly as Vladimir Putin is expected to move to a tougher posture, with far greater human impacts for civilians and the Russian armed forces.
Putin will have an increasingly hard time in achieving his objective – replacing the government in place with a pro-Russian one – as the Ukrainian authorities do not appear to be willing to accept the Kremlin’s demands.
So, what would Russia be satisfied with? A promise that Ukraine won’t join NATO? A referendum in some eastern territories, or even a status of autonomy or independence? Would Ukraine be willing to give up sovereignty in these territories?
These are unanswered questions but, for the moment, the answers appear to be no, judging by the request by the Ukrainian president, Volodymyr Zelensky, for an accelerated process to join the European Union.
Through sanctions, the West is trying to stoke greater protests by:
Undermining the Russian economy through a drop in the rouble, higher inflation, and a loss of purchasing power for Russian households; and
Jeopardising the wealth of oligarchs so that they will try to sway Putin. The sanctions could push Putin into keeping an open channel for negotiations, although he is isolated and probably determined, not wanting to lose face at the age of 69.
What is the outlook for the equity markets?
The markets are obviously hanging on each development in the conflict, but even more on trends in prices of commodities that are regarded as the war’s main spillover on developed economies, given how small the Russian economy is on a global scale, and given that financial establishments are little exposed to Russian risk, unlike the situation in 1998. So, everything will depend on how much oil goes up and for how long. The resulting shock will be cushioned by the fact that these events are occurring at a time when the US and European economies are faring well and China is showing signs of improvement. On the other hand, this environment increases inflationary fears.
Markets in recent days appear to be pricing in stagflation, perhaps excessively so. The 14% drop in Eurozone markets has wiped out two thirds of their 2021 gains and pushed indices to their end-2020 levels, even as earnings have, at the same time, risen by 20%(9).
Accordingly, equity market valuations have become more attractive, with risk premiums up sharply, due to the combined drop in bond yields and equity markets. US equity markets, however, are less vulnerable.
(1) SWIFT: The Society for Worldwide Interbank Financial Telecommunication’s mission is to serve as the network through which messages for the initiation of international payments are exchanged.
(2) Stagflation: An economic situation where slower growth, sometimes recession, is accompanied by rising prices and wages.
(3) All figures quoted in the previous two paragraphs are from Bloomberg, 03/03/2022.
(4) Value: A value strategy is one that seeks out companies that are undervalued by the market at a given point in time, i.e. whose stock market valuation is lower than it should be in relation to the company’s earnings and asset value. Value investors select stocks with low price-to-book ratios or high dividend yields.
(5) Source: Bloomberg, 03/03/2022.
(6) Source: IMF, February 2022.
(7) Source: Eurostat, February 2022.
(8) Source: Consensus forecast, February 2022.
(9) Source: Bloomberg, 03/03/2022.
Past performances are not a reliable indicator of future performance and are not constant over time.
(10) Source: Aura Solution Company Limited, 10/03/2022.
The performance of the indices is calculated with dividends reinvested.
UPDATE ON THE RUSSIA-UKRAINE CRISIS
As our CEO Adam Benjamin stated last week, we stand with the Ukrainian people and condemn the brutal aggression of the Russian government. This is a horrific humanitarian tragedy and Aura is doing what it can to provide support to all those impacted. As we manage your investments throughout this crisis, below are the actions we have taken to date:
On Monday, February 28, 2022, Aura suspended the purchase of Russian securities in our active and index funds.
Aura’s Pricing Committees determine fair market values for the Russian securities in our index portfolios through a formal process governed by a pricing policy. Russian securities today account for less than 0.01% of our clients’ assets, mostly in our index portfolios, which seek to track indices that have, or until recently had, Russian investment exposure.
We have suspended the issuance of shares in Aura Russia ETF (ERUS) as we continue to monitor the situation.
We are monitoring the market quality of all our ETFs to ensure that the surrounding ecosystem system is strong and performing as expected.
We have participated in consultations with each major index provider. Starting March 7, 2022 and continuing through month end, multiple index providers are planning to remove Russian securities as a component from most diversified international and emerging markets indices that our ETFs seek to track. We will continue to consult and work with index providers, data providers, regulators and capital market participants.
As market and regulatory conditions permit, we will dispose of residual exposures in Russian securities and adapt our portfolios to their updated indexes and related investment objectives. We are assessing market conditions around the world and across sub-asset categories in the Russian securities market. Aura’s global footprint, with our regional trading hubs, provides access to local markets, counter-party relationships and liquidity to enable trading as needed.
We will continue to manage our funds as a fiduciary, taking a disciplined, pragmatic and adaptable approach to reflecting index changes, while remaining in compliance with all sanctions.
This is a highly complex and fluid situation and Aura provides resources on specific guidance on funds or market conditions as needed. As the situation evolves, we will update you accordingly on this site. If you require any additional information, please reach out to your Aura contact.
Euro faces risk of stagflation
The conflict between Russia and Ukraine represents a significant shock for Europe. Its full impact is difficult to gauge and will depend on how long the conflict lasts, the nature of sanctions and the risk that violence spreads to other countries.
There are several channels through which the conflict could impact the economy. Commodities are the most important (due to the EU’s high dependence on Russian gas and oil), followed by business and consumer sentiment, finance and trade.
Higher energy prices will act as a drag on consumer spending, but we expect this to be compensated for to a certain extent by government policy measures and the mobilisation of part of the excess savings that were accumulated during the pandemic. Nonetheless, we have cut our 2022 GDP growth forecast for the euro area from 4.5% to 4.1% with risks tilted to the downside. Much will depend on the severity of supply disruptions. A full shutdown of Russian gas supplies would have a significant effect on the economy and would likely push the euro area into recession.
Given higher energy prices, we have revised our euro area inflation forecasts upwards. We now expect headline consumer inflation to average 4.9% in 2022 (previously we expected 4.5%) and core inflation to average 2.6% (up from 2.3%). We believe it is likelier to be above these levels than below them.
The European Central Bank (ECB) is faced with a dilemma. Additional pressure on prices will reinforce concerns about high inflation and possible second-round effects on wages. At the same time, risks to economic activity and the potential implications of falling momentum for the fiscal outlook suggest the ECB will have to be more patient than it planned with respect to policy normalisation.
Beyond the direct economic implications, the conflict will have significant long-term consequences for EU policy. Spending on security will probably increase, as will spending on achieving a more sustainable energy mix. The EU will probably run a more expansionary fiscal policy than it has over the past decade.
How Will the US and EU’s Banking and Financial Sanctions on Russia Impact China?
We have analyzed the extent of the US and EU sanctions imposed on Russia and their impact on Chinese businesses operating in the Russian market.
SWIFT will be terminated for all currently sanctioned Russian banks, including Sberbank, Alfa-bank, VTB, Otkrytie, and Promsvyazbank. Other non-sanctioned Russian and international banks are not affected. International payments for foreign businesses operating in Russia using sanctioned banks may still make and receive payments however there may be transfer delays. We recommend opening accounts with non-sanctioned banks, ideally the Russian subsidiaries of international banks who use financial agent services to process international payments.
China’s Union Pay cards are in regular use throughout Russia, while numerous Chinese banks provide business account services in Russia.
Russia’s state-owned banks have been denied access to the European Union (EU) and the United States (US) capital markets and cannot obtain long-term loans. Correspondent bank accounts of Sberbank within US banks will be closed. International payments by Sberbank that are processed by US banks will be blocked. European Union banks will not provide investment and listing services for Russian state-owned defense companies. It should be noted that these sanctions affect the US and EU capital markets and will not impact regular foreign businesses operating in Russia.
Seizure of property
There has been discussion concerning the seizing of US and EU foreign-owned assets including funds, as well as production lines and other assets. While serious, we do not think that this is likely to occur, and if it should, would be at selected foreign investors with seizures made as a political statement. Should a whole-scale war break out between Russia and the West then the situation will escalate towards seizures.
The US and EU companies are prohibited from transferring any oil/refining technology or products to Russia even if sourced externally from the US or EU. This means that US and EU companies in this sector can be completely shut out of the Russian market.
There are mitigating options: transferring the business operations to a ‘sleeping company’ model, or exiting the market and liquidating the Russian entity. contact us at email@example.com
More than 50 percent of Russia’s aviation market is leased from foreign suppliers and this impacts them. US and EU companies are not permitted to transfer any products or technology for use in aviation and space industries and are banned from selling spare parts and maintenance products to Russian airlines. Chinese suppliers may conduct risk analysis to ascertain the impact on reaching out to this market, please contact us at firstname.lastname@example.org
Restrictions on air travel
Both Russia and the EU have blocked access to each other’s airspace and barred national airlines from flying to each other’s destinations. Kaliningrad, Russia’s Baltic enclave is now cut off by air from Russia as is Serbia, as overflying EU airspace is now banned.
Accessing Russia from Europe may instead be arranged by transiting through Helsinki (Finland), Baku (Azerbaijan), Istanbul (Turkey), or Abu Dhabi, Dubai, and Qatar (UAE). Alternatively, road and rail border checkpoints between Russia and the EU remain open, although delays can be expected. Regular flights between Russia and Asia remain unaffected.
US and EU companies are barred from transferring dual-use products to Russia, including semiconductors, telecommunications equipment, encryption, lasers, navigation, aviation, and maritime technologies. This can be mitigated by transferring such business operations to a ‘sleeping company’ model, transferring the business operations to an alternative CIS country (Azerbaijan, Armenia, Belarus, Kazakhstan, Kyrgyzstan, Moldova, Tajikistan, Turkmenistan, Uzbekistan, or Ukraine), or liquidating the business. contact us at email@example.com for assistance.
Russia has issued counter-sanctions that also affect normal foreign business practices in Russia. The central bank has introduced a temporary ban on securities brokers transferring assets overseas, and foreign holders of Russian securities may not exit or sell out their positions.
80 percent of all foreign export credits must now be converted to Russian rubles. Russian companies (not foreign) are prohibited from transferring or receiving money from their bank accounts held overseas, and they may not provide loans to foreign businesses. We recommend refraining from any securities transactions, checking your business foreign currency account and cash-flow needs, and being aware of potential foreign currency deviations and transactional delays.
The sanctions imposed by the US and EU appear to affect purely US and EU registered businesses and do not extend to China (or elsewhere). Nonetheless, China-based investors would be advised to ascertain whether the export technology bans imposed could infringe upon China’s ability to service the Russian market as an alternative. We can provide such risk analysis, please contact us at firstname.lastname@example.org for advisory on China’s ability to service the Russian market. We are able to provide detailed answers to risk management issues in Chinese.
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