The first quarter of 2022 has shaken the Eastern European region to the core, as the Russian invasion of Ukraine has caused several shockwaves; from security concerns, to economic implications, and of course the humanitarian crisis and influx of Ukrainian refugees. At East Capital, we have seen many crises in the region, spanning from the sovereign debt defaults to financial crises. But this crisis, involving massive loss and costs on human lives and the displacement of millions, is by far the most tragic. Investment activity always carries a large degree of uncertainty, but it is hard to imagine a more challenging investment environment than a war erupting in our investment region, bringing with it direct and painful consequences for people that we know – friends, colleagues, and business associates.
Russia/Ukraine conflict
We came into 2022 expecting growth and new investment opportunities for stock-pickers in a post-Covid economic acceleration. When it comes to the geopolitical tensions between Russia and Ukraine, we deemed any possible military conflict to be limited to the regions of Luhansk and Donetsk, and thereafter planned the consequent sanctions on the markets. One of our scenarios was however a full-scale war, admittedly with a very low probability. The war has invoked unseen harsh sanctions on Russia from the West, including the freezing of USD 300 bn of a total USD 640 bn of Russian reserves, and the country’s ability to act in any G7 currency. The Russian stock exchange has reopened, but trading is restricted to local investors only. After speaking to the Moscow Stock Exchange, we have been informed that trading for foreigners on so called “C” accounts will be opened in the near future. However, the repatriation from such accounts will still be prohibited. So we plan to keep our Russia and Eastern European funds suspended until further notice. All other East Capital funds are open as normal. Nonetheless, we are working in close cooperation with the Russian financial market authorities to work out a path to reopen for trading and reinvestment and, we will be active when the market opens to protect our invested capital and potentially take advantage of opportunities in mispriced assets. We also remain in contact with our portfolio companies, to explore alternative listing venues. Going forward, clearly a lot will depend on the development of the military conflict in Ukraine, which remains fluid and very difficult to predict. From having been spread throughout the entire country, the fighting is now concentrated in the Donbas region, where there has been a military conflict zone for the last 7.5 years. We hope for humanity’s sake that a peace deal is reached as soon as possible, and our focus remains on serving the best interest of our clients and ensuring that when we are able to reopen the funds, we have done everything in our power to maximise value for our unitholders.
Regional implications
Amid the huge uncertainty in the markets, we went to Poland to evaluate the situation on the ground, and our conclusions were rather striking. We noticed the rather assertive mood of the Polish people in terms of their ability to handle war atrocities and stand up for their country, resilience in the high frequency economic data showing only a short dip in confidence after the invasion. And, we felt the strong consumer sentiment, supported by the high activity witnessed in the huge e-commerce parcel depos and retail shops in Warsaw, despite ongoing Covid restrictions. We concluded that Poland will see a positive effect on the economy in the mid term, due to the influx of refugees of up to 5% of the population, improving its demographic situation and labour market, and increasing consumption. Short term, Poland is supporting its economy with huge fiscal programs amounting to up to 3% of GDP, absorbing some of the negative effects of rising inflation. It was also clear that Poland is finding its place amongst the most important countries in Europe, moving away from being just a manufacturing powerhouse towards becoming an important and efficient partner for managing complex military support and humanitarian crises in Europe, which should result in increased future EU support funds. Moreover, the Polish equity market is receiving a massive boost in allocation in the Eastern European benchmarks, increasing from 18% in the MSCI Emerging Europe benchmark to 46%, while the weight of the entire CEE region increases to 68% after Russia has been excluded from the indices, all of which should attract more EM investors looking for investment opportunities in the region.
Global economic implications
The grave human implications have fed through to the global financial markets, with equities declining and bond yields rising. Global markets saw broad-based weakness, as higher commodity prices and Russia’s invasion of Ukraine fuelled inflation concerns. Commodity prices soared given that Russia is a key producer of several important commodities, including oil, gas, and wheat, contributing to a further surge in inflation on top of the existing supply chain disruptions. Elevated inflation is pushing nominal GDP growth to record highs - in many countries reaching 10-15% - levels not seen since the 1950s and 1970s. These nominal growth rates are hardly sustainable and increase the risks for subsequent economic imbalances and deeper GDP slowdowns, as central banks become increasingly more hawkish. During 1Q, we saw the US central bank deliver its first rate hike for the cycle, and another nine hikes are now expected over the coming twelve months, while a balance sheet reduction will soon commence. On top of this, supply chain challenges have prevailed, with no tangible improvements, curtailing production for many companies. The OECD predicts that the current conflict will lower GDP in the EU by 1.4% and in the US by around 1%, compared to the baseline. A gas embargo would result in a further direct hit of 1% to 3% on GDP, and a 3% to 5% hit on industrial production in Europe. And the negative sentiment for Russia is spilling over to China, aggravated by the recent Covid-19 resurgence and lockdowns. However, as China has readjusted its economy, it is still predicted to post 5% growth, driven by fiscal stimulus, benign inflation, and a stable currency, and increasing focus on investments in renewable energy.
Long-term opportunities in the global renewables sector
Renewable energy remains a key theme that interests us greatly. We believe this is an area where we will see secular growth for decades to come. To reach a “Net Zero Emissions” target, as many countries have pledged to do, the IEA expects renewables, as a share of total energy supply, to increase from 12% in 2020 to 67% in 2050, i.e. a five-fold growth during the period. Solar and wind installations are expected to increase to twenty respective eleven times their 2020 levels. In addition, global leaders agreed to rapidly scale up the deployment of renewables and the policies to achieve this during COP26 in November 2021. Furthermore, in 1Q 2022, more countries announced their plans to further accelerate efforts to promote renewable energy and to lower their energy dependency on imported sources. We think this momentum will continue, and we are likely to see the renewable energy sector growing faster and faster, with more policy tailwinds globally. At the same time, renewable energy is also an area where we see many great opportunities. In our investment universe, China plays a major role in the renewable energy industry. According to 2020 shipment data, Chinese companies held eight of the top ten positions for solar module producers, and six out of ten for wind turbine manufacturers, globally. With our supply chain approach, we will thoroughly examine the opportunities in each subsector in order to make off-consensus calls based on our deep understanding of the interactions between companies.
ESG challenges
When it comes to our ESG work, Russia’s attack on Ukraine and the ensuing wave of sanctions imposed on Russia (or self-imposed) have had consequences on our active ownership practices. Several board directors we had nominated, and that were elected to Russian boards, have resigned. Further, it is unclear how and even whether dividends can be paid. And, we cannot vote at the AGMs of sanctioned companies. In more general terms, we believe that ESG investors will have to spend more time and resources on defining - collectively or individually - their responses to ethical dilemmas pertaining to country ESG risk in a more transparent manner, and that ESG values-derived constraints are expected to become more common. In the short term, energy security has taken centre stage over carbon reduction, amid fears of an energy crisis. The war in Ukraine, however, adds to the urgency in reducing our dependence on fossil fuels, and thus will drive investments to diversify and decarbonise energy supply.
Outlook
In this highly uncertain situation, we find markets remaining surprisingly resilient, with global equities down just 5% YTD, and emerging markets down 6%. Markets are being supported by the very long current economic cycle, partially held up by the stimuli. Therefore, the risk for the harder landing remains down the road, but it is unlikely in the short term. The same is true about stagflation – yes, it is possible and could eventually decrease companies’ revenue growth. But in the short term, corporations are benefitting from high nominal GDP growth and so earnings, for the time being, will most likely remain strong. The current environment brings with it risks, and also opportunities for active investors like us to pick sectors and stocks with the most pricing power and “inflation protection” characteristics. Despite higher uncertainty, equities will remain the preferred asset and the T.I.N.A. ("there is no alternative") impetus – which is highly relevant, given the backdrop of increasingly deep negative real rates and high inflation forcing investors to find protection, which equities, as a real asset, do offer. We have been adjusting our portfolios accordingly, focusing on stocks with shorter durations and lower valuations, and avoiding more expensive parts of the market. We think there will be more opportunities to scoop the growth stocks down the road, even if admittedly, many of them did correct significantly and their valuations are becoming more reasonable. Though we note the latter can be fairly short-lived as more traditional value stocks often display sub-par profitability and a lack of structural growth, which makes them less appealing as long-term investments.
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