One country’s war could be another country’s windfall


George Glynos, Director and Head of Research & Analytics, ETM Analytics 


Bottom Line:
• War is deplorable for every humanitarian reason one can think of. It rips families apart, lives are lost, destroys economies and livelihoods and generates a set of consequences most people would prefer to live without. One can debate the response to such military behaviour ad nauseum, but no perfect solution will be found. The consequences will be profound and still need to be dealt with.

• This article does not debate the merits of sanctions, or the ill-advised behaviour of Russia, but rather seeks to unpack what the consequences for SA, and the rest of the world might be. It is early days and we do not claim to understand it all, but there are some developments worth taking note of that do hold implications for many countries including SA.

• As it turns out, there are some reasons to be less bearish on SA than some investors might expect from a sub-investment grade emerging market. The analysis below shows how SA stands to benefit from the sharp jump in commodity prices that have once again boosted SA’s terms of trade. It may well turn out that SA could sail through this latest crisis with far less disruption due to its ability to supply minerals and coal to a market desperate to diversify itself away from Russia and seeking an alternative to Ukrainian supply.

Baseline View:

The ZAR may well remain more resilient than anticipated. A strong commodity cycle has been resurrected due to the sharp rally in commodity prices. It implies that the ZAR could even trade back below the 15.00/dlr handle if overall risk appetite returns and terms of trade remain favourable.


War and its devastating consequences for all

Wars always have devastating consequences on everything and everyone exposed to them. Each war is different, and the destruction that they cause may vary, but they are always costly in human life and typically impose dire economic consequences. Russia’s war on Ukraine will be no different, and there are early indications across various financial markets that may give us a taste of what we might expect going forward.

Russia’s illegal and unprovoked invasion has attracted widespread criticism, sanctions and financial repression from the West to leave Russia isolated and facing economic and financial ruin. The most immediate sign of just how desperate things are about to become in Russia is evidenced in the collapse of the Russian Rouble, which depreciated from RUB 75.00/USD to around RUB 113.00 in just one week.

All indications are that there is a lot more where that came from, especially if the world starts to find alternative oil and gas production sources, which have thus far generated a source of USDs for Russia.


Massive destruction of value

Substantial losses have been recorded across equity markets, with the worst hit being Russia and Ukraine. Still, the developments have also weighed on other stock markets as investors priced in the prospect of greater difficulties for Europe and the outside chance that the violence might escalate to a full-blown nuclear stand-off.

GDP growth will be revised down. The extent of the revision will depend on the length and intensity of the war and whether Russia is prepared to stomach the fallout of the sanctions to secure its geopolitical ambitions. Europe will need to rethink their trade ties to Russia seriously and undertake significant reforms in generating and consuming energy. It may initially be at odds with their climate change objectives, but the alternatives would be severe growth constraining. Just the wealth impact alone holds the potential to wipe out any of the gains that the EU economy had made in the recovery from Covid. This will hold major implications for economic policy, both monetary and fiscal.


Energy prices have Rocketed

This is obviously the consequence most households and businesses will feel almost immediately. Northern hemisphere winter is not yet over, and energy prices are alarmingly high. In particular, natural gas prices are now more than 400% higher than they were in July 2021, rendering it unaffordable to many. Given Russia’s dominance in supplying Europe with gas, the war has simply made an uncomfortable situation desperate.

Inflation will be the main direct consequence of this and raises the possibility that the world may be staring at a stagflationary episode where very high inflation levels will accompany feeble GDP growth.

Making matters even more challenging is the realisation that Russia is such a global player in oil and gas that it will be difficult to transition away from its supply.

Geopolitically speaking, sanctions on Russian energy could have crippled the Russian war machine very quickly. However, these are the very sanctions that the West cannot afford to impose. Indirectly, the demand for Russian energy is what has funded the very war the West is fighting against.


Not all bad news for SA
Unwittingly, South Africa has found itself in the fortuitous position of being exposed to some of the commodities and minerals affected by the war. Ukraine is a mineral-rich country. Amongst other minerals, it produces 40% of the world’s palladium. SA does produce some palladium but is also a significant platinum producer, which can be a substitute should the price of palladium rise too quickly. Add to that the rise in the gold price as a hedge against inflation and geopolitical risk, and the rise in coal prices as countries seek alternatives to gas to fuel their electrical production, and SA stands to enjoy another unexpected mineral windfall.


SA’s terms of trade improve

The combination of the findings above have translated into a sharp improvement in SA’s terms of trade. They are now as strong as they were during the pandemic when the ZAR surprised with its resilience to all the bad news.

This time around, the situation is different. SA is not staring down a fiscal abyss. Its economy is gradually recovering from the pandemic. The latest budget showed clear signs that the government is seriously considering some growth positive reforms that would include the crowding-in of the private sector in industries previously dominated by SOEs.

The latest disappointing trade figure is therefore likely to improve in the months ahead as SA enjoys yet another commodity windfall that will not only boost the GDP contribution of the mining sector, but further reduce the budget deficit and protect the SA economy from shedding more jobs.


SA’s carry attractiveness is supportive of the ZAR

The strong rise in SA’s terms of trade, coupled with the rate hikes already announced ahead of more to come, have ensured that the ZAR retains some attraction to foreign investors. SA’s fiscal risks also dissipate with the commodity price windfall that SA now enjoys due to the Ukraine war, and SA enjoys a silver lining to this latest crisis. SA ranks near the top of the carry attractiveness, narrowly missing out on the third position to Chile.

Things could be far worse if SA ranked poorly on this measure. It would mean that interest rates would need to rise sharply to attract foreign capital and that the growth outlook would take a sharp turn for the worse. Instead, this rise in carry-attractiveness allows the ZAR to remain more resilient than many other currencies, which shields the SA economy against an even more severe inflationary shock.

This also goes a long way to explaining why the ZAR has confounded many of its detractors by performing as well as it has. Given how the war appears to be intensifying, the short-term upside may even turn the balance of forces in the ZAR’s favour, and while there are LATAM currencies that may look more attractive by this measure, the ZAR would be in good company as an EM currency with high levels of liquidity, sophisticated markets and a European timeline which only enhances its attractiveness and tradeability.


Longer-term outlook may be more upbeat for stocks
From a broader equity market performance, all is not lost. Although the findings can vary, three out of the previous four wars have resulted in equity markets gaining ground in the US. A similar picture arises when looking at the JSE. This may sound and feel counterintuitive, but it makes sense when one considers that the initial reaction from policymakers would be to protect growth through the easing of monetary and fiscal policies. This time might be slightly different as the world enters a phase of rate hikes. Still, nothing is stopping the central banks from once again prioritising growth above inflation in a bid to shield global employment from yet another hit so soon after the Covid-19 pandemic. Expansionary monetary and fiscal policies will over time ensure that equity markets rise, so long as the war remains more localised and does not escalate into something approaching another World War.


Risk appetite may therefore prove more resilient

It is easy to assume that war should justifiably translate into an automatic rise in risk aversion, and therefore emerging markets should be marginalised and sold off. However, such developments are a little more nuanced than that. Of course, it matters that there has been a massive geopolitical event that could derail growth in a key economic region, but against that, one needs to consider the consequences before trading on anything at face value.

The first consequence is that major central banks will become more cautious in hiking rates. The Fed has already admitted that the war is a “game-changer” and that they should only increase rates “gradually” finally adding that it needs to remain nimble of the situation changes. This is a significant development that can change things for risk markets, including emerging markets. Emerging markets, especially LATAM and SA, have surprised investors by attracting foreign capital. They are commodity currencies and countries that stand to gain from the disruptions in Europe, even if that comes attached with more challenging demand conditions.

The above chart also highlights quite neatly that EM currencies have no immediate need to sell off if risk aversion does not escalate materially due to expenctations of significant collapse in GDP growth. It goes towards strengthening the argument that the safest place to be right now may be in emerging markets. Quite counter-intuitively, emerging markets may have gained prominence as a relative safe haven in a world where major superpowers are embroiled in conflict and where the major geopolitical risks reside on their borders.


ETM’s ZAR Sentiment Indicator implies a convincing move back below 15.0000

ETM’s ZAR Sentiment Indicator has moved back into positive territory on the smoothed version (darker blue line). Even the higher frequency version of the indicator hovers around neutral levels, ultimately implying a USD-ZAR move back below 14.50/dlr. That is a very interesting development and in essence, corroborates the findings above.

Recall that this indicator derives its output from data obtained in the traded options market and reflects how the professional market is positioning itself given the available information. It suggests that the current spike in commodity prices has led investors to price in strong trade and current accounts due to the improved terms of trade. However, there are other reasons, including an improved fiscal outlook and more breathing room to implement much-needed reforms that will also bolster the ZAR. One thing is clear, the current war on Ukraine is not translating into a depreciative bias on the ZAR.