3 March 2022
Russian freeze
Fixed income investors are feeling the chill from sanctions on Russia and the rising risk of stagflation. We assess the implications of the Russia-Ukraine conflict across the global fixed income market.
Fundamentals
The conflict in Ukraine and the toll it is taking on human life is deeply distressing. Russia’s invasion has been met with sweeping sanctions, which have also led to significant increases in commodity prices. While there are many nuances to the Russian-Ukrainian conflict, there are two pertinent questions for fixed income investors: what does this mean for global growth and how will policymakers respond?
From a growth perspective, the latest developments are a supply-side shock that will likely to lead to slower economic growth while inflation remains persistently high. These pressures are likely to be felt most acutely in Europe, which is already suffering from the highest level of inflation since the introduction of the single currency and is most susceptible to cuts in Russian gas supply.
For central bankers, the possibility of stagflation is a daunting conundrum. Tightening monetary policy would help stabilise rising inflation expectations but could hurt economic growth; looser monetary policy might support growth but would likely de-anchor inflation expectations further. Ultimately, the core objective of central bankers is to target inflation. The European Central Bank may opt to delay possible rate hikes until 2023 and seek to extend its asset purchase program further. The US Federal Reserve, the Bank of England and the Bank of Canada are likely to continue hiking rates, albeit at a slower pace than initially priced in before the conflict.
Inflation continues to beat expectations
Source: Eurostat. Data as of 28 February 2022. HICP = Harmonised Index of Consumer Prices.
Quantitative valuations
The suspension in trading of Russian-based securities has made valuing country-specific assets particularly challenging. Outside of Russia, broader markets remain orderly, although bid-ask spreads are wider and liquidity conditions are more challenging. The risk-off move has prompted a rally in government bonds, reinstating their importance as a valuable hedge for investors’ portfolios. In credit markets, rising commodity prices and their impact on corporate profitability has triggered spread widening. In global investment grade credit, option adjusted spreads (OAS) widened to 136 basis points (bps), the highest level since mid-2020. Similarly in European high yield markets, OAS widened by 35 bps over the week ending 1 March. Emerging market debt has been hardest hit, with spreads widening by 100 bps over the same time frame as investors sought to reduce their exposure to the asset class.
Technicals
During these shocks, contagion can exacerbate the initial impact by spreading risks across the broader financial system. However, since the annexation of Crimea in 2014, investors have sought to reduce their exposure to Russian-based assets, helping to limit the extent of de-leveraging that has occurred across portfolios. While investors have sought to de-link from Russia, the risk of contagion has not been entirely mitigated. The suspension of Russian banks from SWIFT is a rarely utilised sanction that is not entirely understood by market participants. By suspending access, Russian-based debtors might be willing and financially able to make payment but no longer have the practical means to transfer the funds, therefore triggering technical defaults across the financial markets. Investors should be mindful of these logistical headaches in the coming weeks, especially in the event of a protracted conflict.
What does this mean for fixed income investors?
The attempts of Western governments to freeze Russia from the global economy and financial system has been a cold headwind for bond markets. At this juncture, the uncertain growth and geopolitical outlook likely poses more questions than answers for investors. We remain wary of core rates duration, as ongoing inflationary pressure still suggests that monetary policy will tighten, although at a slower pace than initially forecasted. With potential delays to monetary policy tightening and more attractive valuations, investors would be forgiven for thinking that now represents an attractive time to buy risk assets. In reality, the possibility of stagflation and the ongoing geopolitical tensions mean that while valuations have cheapened, they are not yet cheap enough to justify the risks.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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