Implications of the Russia-Ukraine Conflict...Plus: Is China's Property Market Healing?

[Goldman Sachs]( [BRIEFINGS] March 3, 2022 Implications of the Russia-Ukraine Conflict Russia’s invasion of Ukraine has resulted in — above all else — a humanitarian crisis. The conflict is also reverberating across global economies and markets. In the [latest episode of Exchanges at Goldman Sachs]( host Allison Nathan explores the implications with her colleagues across Goldman Sachs Research. The outlook for monetary policy is mixed. Commodity prices are moving sharply higher given Russia’s role as a major producer and exporter of oil, gas and other commodities, which is feeding through to higher inflation and tighter financial conditions, says Daan Struyven, senior global economist. The higher inflation, combined with lower expected economic growth, is creating a mixed picture for central bank policy. “Markets clearly seem to be emphasizing the dovish side of the ledger here with a pretty large move in, for instance, front-end rates, both in the U.S., the euro area and other G-10 markets,” he says. “Our own baseline views, both for ECB and the Fed, remain quite hawkish.” Equity risk premiums are rising. Investors are getting nervous about holding equities, especially European stocks, as reflected by rising risk premiums, says Peter Oppenheimer, chief global equity strategist. “The difficulty when we get a shock event like this — which has so many consequences, of course humanitarian, economic, and monetary in terms of policy — the uncertainty levels go up,” he says. “The equity risk premium [the extra return investors can expect for buying stocks over risk-free government bonds] has shot up much more, in fact, than most other geopolitical events have triggered over recent years or even decades. But that's understandable because the consequences of this are far-reaching and could be quite long-lasting.” Emerging markets at risk. The U.S. dollar is rising amid a flight to safe-haven assets while risky assets, such as emerging markets that are “closest to the theatre of conflict,” could fall further, explains Kamakshya Trivedi, co-head of Global Foreign Exchange, Interest Rates and Emerging Markets Strategy Research. “If that perception of cyclical risk broadens out — either because the crisis escalates or because the inflationary impact is seen as being big enough or important enough that central banks have to raise rates further — I think a lot of risky assets like EM assets that are levered to cyclical risks...could see more pressure,” Trivedi says. [Listen to podcast]( SHARE: [twitter]( [facebook]( [LinkedIn]( [email](mailto:?subject=What%20the%20Russia-Ukraine%20Conflict%20Means%20for%20Markets&body=https%3A%2F%2Fwww.youtube.com%2Fwatch%3Fv%3DlSYOizQWUMw) How ‘Shadow’ Sanctions Are Affecting Russian Oil Traders are avoiding Russian oil even though energy hasn’t been swept up by sanctions. That’s showing up in the divergence between prices for Russia’s flagship Urals oil grade and global benchmark Brent crude, based around the North Sea. “The market is still concerned,” says Damien Courvalin, head of energy within the commodities research team. “It’s really the shadow of future sanctions, and that’s led to a reluctance to trade in Russian commodities.” The reluctance to trade Russian crude oil is creating a small disruption even without sanctions. But that’s likely to fade if energy remains exempt from restrictions imposed on Russia by the likes of the U.S. and EU. “So far energy as a basic necessity is being carved out and that remains our expectation going forward,” Courvalin says. “The clearer it gets that energy isn’t included in sanctions, the more this normalizes.” Alternatively, if traders continue to resist buying Russian oil, or if energy sanctions materialize, crude prices could jump substantially higher, Courvalin says. Crude could increase to as much as $150 per barrel in the coming months if that takes place, as there’s not enough supply immediately available to make up for the shortfall. SHARE: [twitter]( [facebook]( [LinkedIn]( [email](mailto:?subject=How%20%E2%80%98Shadow%E2%80%99%20Sanctions%20Are%20Affecting%20Russian%20Oil&body=) How Much Risk Is Priced into Global Assets Now? [In a recent Goldman Sachs Research note]( Dominic Wilson and Vickie Chang looked at how different assets have responded to heightened geopolitical tensions in February and compared those measures with current market conditions. Their analysis shows that while many global assets had a blanket risk-off response, they have since begun to price in differentiated amounts of risk. In recent days, the market appears to be pricing the greatest amount of risk in local and regional assets and a high amount of risk in emerging market and European assets. Other global assets — U.S. equities, credit, bond yields, Japanese equities, FX and gold — appear to be pricing in less risk now. U.S. rates initially priced less downside risk than the rest of the global asset complex but have bounced back less than similarly exposed assets like U.S. equities. According to Wilson and Chang, this suggests that investors may be overestimating the impact of the Russia-Ukraine conflict on the Fed policy outlook and that short-term yields could reverse their recent declines, as they have already begun to do. [Read report]( SHARE: [twitter]( [facebook]( [LinkedIn]( [email](mailto:?subject=How%20Much%20Risk%20Is%20Priced%20into%20Global%20Assets%20Now%3F&body=https%3A%2F%2Fwww.goldmansachs.com%2Finsights%2Fpages%2Fglobal-markets-daily-how-much-risk-is-priced-into-global-assets-now.html) Briefly…on the Outlook for China’s Property Sector Are there signs of healing in China’s property sector? When the indebted property giant China Evergrande Group started defaulting on its payments last fall, fear spread that a potential bankruptcy would trigger a broader crisis in China’s debt markets — and global markets more broadly. Several months later, defaults on Chinese property bonds continue to remain elevated. We spoke with Kenneth Ho from Goldman Sachs Research and Salman Niaz of Goldman Sachs Asset Management for their views on Chinese property credit and the Asia high-yield sector more broadly to understand what has changed. Property developers’ debt-repayment problems have been among the biggest issues roiling Asia’s credit markets over the past year. Kenneth, as Goldman Sachs Research’s Asia credit strategist, how are you thinking about the China property high-yield market today? Kenneth Ho: Credit conditions remain very tight. It feels that the market is still under a lot of stress, as a lot of easing measures from China policymakers have been piecemeal and haven’t led to a big impact on the physical market, and companies are still having trouble making payments. Our expectation going forward is that you would get more easing but at the same time you get more defaults. In 2022, we have a base case estimate for a China property high-yield default rate of 19%. Last year was over 28%, so it’s still at very elevated levels of defaults. Saying that, we do expect the stronger companies to survive, and these bigger, stronger companies are ultimately going to be the main beneficiaries of policy easing as lenders feel more comfortable extending credit to stronger companies. This will create winners and losers. It’s hard to speak in terms of opportunities — it continues to be a difficult environment. We do think you can generate decent returns from China property high-yield but the risk around that is very high. Our view is to stay at the very high end and be diversified and wait for news to come before making a more definitive directional stance. You don’t want to be overly concentrated on specific issuers as idiosyncratic risks remain high. So it’s a neutral view; stay up in quality and be diversified. 2022 hasn’t gotten off to an encouraging start. How much more pain could China’s property market see — and could we turn a corner? Kenneth Ho: You have to ask, what’s the ultimate aim here? It’s a medium-term deleveraging of the property sector. This is after a massive credit boom in China, post the global financial crisis. It’s trying to deleverage the property sector without causing a systemic crisis. Policymakers are being very pragmatic as we move along, introducing policy easing to cushion the downside effects without deviating from their medium-term goal. It’s likely going to be volatile in the coming months. The physical market likely won’t stabilize until the later part of this year, which means there will be an extended period of volatility. We think the key here is on policy. Our 19% estimate for a China property high-yield default rate this year is based on more piecemeal easing, which will eventually stabilize the sector, but it is a long grind. More defaults will come. And if easing comes at a slower pace, more companies will default and it will be closer to our downside case of 31.6% for default estimation. It all really hinges on policy outlook. It’s been difficult — the way policy has shifted in the last year has been a surprise to many market participants. Salman, let’s get your thoughts on the investment opportunities given your role as head of Asia Credit for Goldman Sachs Asset Management’s Emerging Market team. How are you approaching investment opportunities in Asia’s high-yield sector more broadly? Salman Niaz: We approach the asset class recognizing structural value and attractive total return potential, but with heightened uncertainty in the near-term, emanating from the Chinese high-yield property sector which continues to remain under significant pressure. Utilizing our preferred benchmark as a starting point, which benefits from a relatively high degree of regional diversification and is based on a range of potential default rates and recovery scenarios, we calculate potential cumulative return expectations over two years of between -2% and 24%, as of January 31st. To get -2% you have to believe that almost two-thirds of Chinese property high-yield will default during 2022 from here, and expect a 10 cent recovery for every dollar invested. To get to a 24% return expectation, you have to believe that a quarter of Chinese property high-yield bonds default this year. This leaves us with two important conclusions for investors. Number one: diversification is critical to help mitigate downside scenarios. And number two: If you are well diversified, the asymmetry of returns is heavily skewed to a positive return scenario (the downside is minimal even in a disaster scenario). But with the elevated default risks in the sector as Ken just explained, diversification is the way to invest. We evaluate the return expectations we have for the market over a two-year cycle rather than one, as the visibility on restructurings and recovery is likely to be much higher in 24 months than in 12. While it may be early to get too excited about the investment opportunity in China property high-yield bonds, a recent restructuring proposal made by a Chinese property high-yield company highlights the potential for high recoveries. A mid-sized developer that defaulted in Q4 2021, has offered a par-for-par amend and extend proposal for offshore bond holders offering a package that could be worth 65-75 cents of present value assuming high discount rates. If other China property companies follow suit — and the sector stabilizes — the total returns could well be towards the high end of the range mentioned above. For more on investor positioning and risks, [read the full interview](. 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