07 MAR 2022
While some indicators of financial stress appear more sanguine than in the aftermath of 1998 Russia default, there are some genuinely troubling elements to the current episode that were not present before. Each crisis manifests itself differently. Financial contagion from a default appears to be capped; the global banking system is now in a stronger position, exposure to Russian assets is modest and liquidity mechanisms are in place. That said, credit risk premia on global banks (CDS spreads), corporate credit spreads and FRA-OIS funding spreads have widened materially over the two weeks (chart 1). It is plausible that a liquidity crisis has commenced.
As we noted last week, most of the recent deterioration in risk perceptions was already underway from the anticipated collective central bank tightening this year. Moreover, there was also already pressure on energy and commodity prices due to demand (re-opening) and supply side constraints. Put another way, the economic sanctions have amplified trends in commodity prices and headline inflation that were already in place.
Our fear is that the sharp rise in energy prices has taken spot to a level (above $125 and greater than 50% year on year increase) where it has historically contributed to and oil shock recession (chart 2). As we noted last week, and is now widely appreciated, Russia accounts for 41% of European gas imports and 10% of global oil production. Other commodities such as nitrogen fertilisers, palladium, copper, nickel, potash and aluminium are also important. Ukraine and Russia are also large grain exporters. The price squeeze in these commodities is now well appreciated, but a legitimate risk for production, global growth, corporate profits and markets.
The good news, is that a prerequisite for a rebound in risk appetite and equity market performance is for the prevailing bias to reach outright pessimism, panic or capitulation. Our sense is that this process is underway. On the negative side, it is possible that risk appetite can remain pessimistic for a while and the rationale for the current market panic is legitimate as the odds of a oil shock recession have increased materially over the past week. However, it is also probably too late to pay for protection, especially in equity with spot volatility and skew already elevated.
Risk compensation in credit is probably the least expensive, but has also increased to levels experienced during policy induced panic/tightening episode in Q4 2018. Of course, if there is an outright recession, credit risk premia probably ought to widen further over the coming months. In this region, the additional point to note is that the valuation equity risk premium in Asia is both attractive in outright terms and relative to the United States. However, given the legitimate risk of an oil shock recession we will be cautious in scaling back into long equity exposure.