Russia-Ukraine Crisis & Equity Markets

Article Shared by IIFL AMC

Indian Equity Markets: Treading through geopolitical jitters!

As the tensions between Russia and Ukraine turned into a full-fledged war, the risk-off environment in global equities worsened. The risk of supply disruption across commodities that were already in tight situations has triggered jitters and pushed the prices up. The risk of stagflation has been rising and is being priced in gradually. The key benchmark indices S&P BSE-30 and Nifty- 50 indices were down 3.0% and 3.1% respectively in the month ended February 2022. The indices down the capitalization curve underperformed the key benchmark indices. S&P BSE Mid-cap index recorded a monthly loss of 5.1% and the S&P BSE Smallcap index registered a monthly loss of 8.8%. Amongst the sectoral indices, S&P BSE Realty, Oil & Gas, and Auto were amongst the biggest losers correcting 9.1%, 7.3%, and 6.8% respectively. On the other hand, only BSE Metals and Consumer Durables closed in green recording monthly gains of 9.5% and 2.8% respectively. FPIs continued to be net sellers for the fifth consecutive month, to the tune of $4.7 bn in February’22. However, DIIs were net buyers to the tune of $5.6 bn in February’22.

Amongst the key global developments during the month, the Bank of England (BoE) and Reserve Bank of New Zealand (RBNZ) raised their key policy rates by 25 bps to 0.5% and 0.75% respectively. Other central banks such as ECB, PBoC, and BoK maintained the status quo on rates. Back home, the Indian government delivered a moderately positive Union Budget with enhanced quality of accounting and reasonable budgeted growth in capital expenditure. Further, RBI kept policy rates unchanged, government-issued a green hydrogen policy, and 3QFY22 real GDP growth came in at 5.4%.

The manufacturing PMI expanded and came in at 54.9 in February’22 as against the print of 54.0 in January’22. The gross GST revenue collected in February’22 stood at INR 1.3 trillion, up 18% YoY but was lower on an MoM basis due to some impact of the Omicron wave.

Q3FY22 real GDP growth surprised on the downside and came in at 5.4% (vs. 8.5% in Q2FY22), which was lower than market expectations. Exports were robust while domestic demand was slightly weaker than expected. Real GFCF growth fell to 2%YoY in 3QFY22 from 14.6% in the previous quarter. Due to lower support from pent-up activity, sequential momentum for utility, mining, and construction sectors was more subdued. Meanwhile, the unlocking aided the sharp recovery in contract-based services. Real GVA Services growth was strong at 8.2%YoY in 3QFY22 compared to just 0.2%YoY growth in the Real GVA Industry. In spite of the base effect, the activity of the service outperformed the manufacturing activity.

Rising risks of Stagflation

While India’s direct trade exposure to Russia and Ukraine is limited in terms of both exports and imports, it is significantly

exposed to the rise in oil prices as 85% of India’s crude requirement is met by imports. The recent up-move in the oil price of around

$40/bbl YTD can negatively impact the current account deficit (CAD) by 200bps if it sustains around these levels and also drive inflation higher by more than 100bps. While global demand cannot support these levels, supply constraints may keep prices elevated till the war ends. Also, a sharp increase in prices of petroleum products would weaken demand for the same and negatively impact automobile demand. Overall, growth could slow down while inflation can rise further leading to higher risks of stagflation in the economy.

Sectoral Implications

Sector	Implications
Oil & Gas	Upstream oil companies are the only beneficiaries of this sharp up-move in crude price. Downstream oil marketing companies are incurring large losses (Rs 20-24/litre) and there is an immediate requirement of price hikes or reductions in excise duties. Similar price pressure is seen in the city gas distribution segment. Heightened uncertainty may continue till the Russia- Ukraine situation improves.
Metals	Russia’s share of global consumption of major commodities is <5% (except Gas, consumption of which is more localized) while Russia has a bigger share of global production in metals (>5% in Coal/Steel/Iron Ore/Aluminium). Both ferrous and non-ferrous companies have seen positive impacts led by supply chain disruptions. Apart from a direct positive impact for certain commodity companies, this would also have an indirect negative impact on quite a few metal-consuming companies.
Auto	The industry is likely to witness improvement in semiconductor supplies in FY23; however, a protracted Russia-Ukraine crisis could create new supply chain constraints. Sharp vehicle price increase to pass on higher commodity costs along with impending fuel price increase could weaken demand in the short term while medium-term prospects remain intact.
Cement	Given the sharp rally in coal & pet coke prices and impending steep hike in diesel prices, cement companies are likely to witness severe margin pressure in the short term. Companies are likely to gradually pass on the cost increase, but the quantum of the hike would depend on on-demand environment.
Consumer	Sharp leg of commodity cost inflation especially for crude oil and palm oil post the escalation of conflict in Ukraine would impact consumer companies having a portfolio of soaps and foods. Further, homecare products, packaging, freight costs are also expected to see an up-move. As seen in the past, inflationary pressures are dealt with by taking judicious price hikes, cost efficiencies, and rationalizing discretionary spending, to limit impact at the EBITDA level. Having said that, we do see some negative impact on near-term volume growth as continued price hikes coupled with weakening rural sentiment would result in a pause in the premiumization journey of most of the companies. Companies with higher exposure to discretionary portfolios catering to urban consumers will be relatively resilient.

IT Services	Indian IT services companies have negligible exposure to Russia and Ukraine. Also, there is no direct impact on commodity prices while currency depreciation should be positive. However, we would closely watch the potential impact on overall IT spending in key markets
Financial Services	The lending companies (Banks, NBFCs) have seen improving asset quality trends over the last few quarters. In the current backdrop, we continue to monitor the impact of current macro and geopolitical issues on domestic demand and overseas book asset quality for companies. Growth was expected to improve and as things normalize ahead that could pick up. RBI is expected to raise rates during the year and an increasing interest rate environment is good for the bank’s margins in the initial few months which should add to the financial performance of the leading companies.
Pharma	Impact of Russia-Ukraine war on pharma companies is on various front viz. Ruble depreciation, de-prioritization of Russian markets, raw material cost increases due to shortage of Russia- linked key starting materials (KSM), and loss of volume from Ukraine as it is the war ground. Certain Indian companies having material exposure to Russia would be most impacted. Companies having more exposure to the domestic market are least vulnerable in this environment.
Industrials	Industrials companies are exposed to all the key commodities (Crude oil, Steel, Aluminium) which have seen a sharp increase in prices. However, the impact will vary depending upon (1) Project vs product type of industrial companies and also (2) Short cycle vs long cycle companies. Companies that are short cycle and have higher exposure to products in the portfolio will witness the lower impact on margin vs companies having a long cycle and high project mix in the sales. Overall, rising pressure on government finances could soften the pace of government CAPEX and delay the impending CAPEX cycle recovery.
Chemicals	Chemical companies are impacted by (1) Higher crude-linked raw material (RM) prices and (2) Supply chain disruption impacting the availability of RM and sales and (3) Higher coal prices. However, the degree of impact will depend on the nature of chemical companies i.e. specialty vs. commodity. Thus, companies falling in the crude linked product value chain will witness a higher impact on margins compared to fluorine-based chemistries. We believe the margin impact on specialty and fine chemical companies will be lower and transitory as higher RM prices will be passed on within a quarter or two.

Outlook

The recent leg of the rally in commodities on a base that was already elevated has pushed out the margin recovery of Indian corporates by a few quarters. Crude is a commodity that impacts India significantly and poses a severe risk to our base case assumption of cyclical recovery. More than the absolute level of crude, what matters is the duration for which crude prices remain elevated. A sustained price above $100 levels would not only dent the current account deficit and local currency, but it would also force RBI to adopt the hawkish approach in the monetary policy.

It is difficult to take a view on the duration of the current geopolitical tensions. Given the uncertainty in the short term, we would like to have a balanced approach in our portfolio strategy. We continue to remain believers in the domestic cyclical recovery over the medium term while also having a good presence of secular businesses in the portfolio.

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