Russian Tensions Weigh on German Equities -- Update

By Tommy Stubbington 

Tensions between Russia and the West over the conflict in Ukraine are casting a darkening shadow over much of Europe's economy, but Germany's markets in particular are feeling the strain.

Investors have rushed to Germany's ultra-safe bonds--pushing them to record highs, while stocks have found themselves in the firing line.

Frankfurt's DAX stock index, packed with the exporters and industrial powerhouses that are the engine of Europe's largest economy, has fallen 7.8% in the last month. That compares with a fall of 4.4% for the pan-European Stoxx Europe 600 index. Outside the euro zone, the U.K.'s FTSE 100 and the S&P 500 are both down by less than 3%.

European Central Bank President Mario Draghi underlined Thursday that tit-for-tat sanctions between the European Union and Russia pose risks to euro-area growth as a whole. But Germany's high profile, deep markets, and large exports to Russia make its stocks more vulnerable.

"There's a perception of German industry and Russian energy being closely intertwined," said Neil Wilkinson, a senior fund manager at Royal London Asset Management, which oversees $76 billion of assets. "We have a big universe of stocks we can invest in. With so much uncertainty, it's pretty hard to justify holding firms with a big chunk of their business in Russia."

The latest wave of Western sanctions last week targeted sectors such as finance, oil and defense, tipping Russia's slowing economy toward recession. Russian President Vladimir Putin hit back Thursday, imposing bans on imports of food and other products from the nations that imposed the restrictions.

A number of German firms have already flagged a slowdown in their Russian businesses.

Sporting goods company Adidas highlighted a deteriorating Russian economy when it last week issued a profit warning that sent its shares plunging. The chief executive of engineering giant Siemens said geopolitical tensions arising from the Ukraine conflict are a "serious risk" to Europe's growth.

Some investors are steering clear of German stocks, favoring the likes of Spain and Italy from Europe's erstwhile trouble spots known as the periphery instead.

"[Economic sanctions on Russia] are a constraint for certain companies. That's the reason we prefer peripheral stock markets to Germany," said Gregor Hirt, chief investment officer for Europe at UBS Global Asset Management, which manages $674 billion of assets.

Germany is responsible for 30% of European Union goods exports to Russia, according to data compiled by RBC Capital Markets. Although only 1.3% of Germany's gross domestic product, that's the largest share of any major European economy.

The standoff over Ukraine could also disrupt the westward flow of energy as well as the eastward flow of goods. Russian natural gas accounts for nearly half of German gas consumption, RBC says.

As stocks decline, Germany's government bond market--the euro zone's safest and most liquid--has benefited. The German 10-year bond yield on Friday sank to an all-time low of 1.02%. Yields fall as prices rise. Yields on two-year German debt this week turned negative for the first time since May 2013--meaning investors are once again happy to pay the German state simply in order to park their cash.

To be sure, other European economies also have strong links with Russia. Finland, for example, imports all of its gas needs through Russian pipelines. "There is a possibility of a crisis, if the situation continues to develop as it is doing," Finnish Prime Minister Alexander Stubb told reporters this week. But Germany's high profile and large international financial markets put it uppermost in many investors' minds.

For some, the pressures on German stocks are symptomatic of a worsening outlook for euro-area markets as a whole.

"If the sanctions last, we could see a permanent loss of business for some companies with substantial sales in Russia," said Patrick Moonen senior equity strategist at ING Investment Management, which has EUR322 billion of assets under management.

Mr. Moonen said the vulnerability of the region's economy to an escalation of tensions with Russia was a key driver for a decision earlier this week to scale back holdings of euro-zone stocks and buy emerging-market equities instead. ING IM is now underweight euro-area equities.

Write to Tommy Stubbington at [e-mail]

Subscribe to WSJ: http://online.wsj.com?mod=djnwires