It’s not shocking that Russian President Vladimir Putin has moved to take advantage of the current geopolitical backdrop. For starters, with US midterms looming and an Afghanistan-related black eye, there certainly seems to be little appetite for the Biden administration to take on an aggressive Russia head-on. A weaker NATO that was exposed during the Trump administration also has emboldened such an incursion. Also, we should not forget that the politically charged global inflation concerns and almost triple-digit oil prices serve Russia well.
What Does It Mean for Markets?
Historically speaking, military conflicts have been short-lived, and equities have often rallied at or just before the point when the tanks roll across borders. The Vietnam War, Gulf War, Afghanistan War, Iraq War and Crimean Crisis all saw equities move down in the immediate aftermath of the conflicts’ beginning. But then markets moved higher in six months, with cyclicals often leading the charge.
Will this time be any different? Who knows. But history lends itself to a pretty good blueprint. Obviously, a further push into Ukraine and Kiev by the Russian military will change the dynamics. Also, the longer this plays out, the greater the impact will be to global markets, we believe. Keep in mind, the Russian economy is relatively small compared to the US, China, Japan and the majors in Europe, and it receives a small share of European Union exports.
Here are some specific thoughts on the markets and reactions to Russia’s maneuvers:
An Energy Shock Is the Main Risk to the System.
And this will have an outsized impact on the EU economy:
- Europe imports about 40%–50% of its natural gas from Russia, with Germany falling on the higher end of that range. Ukrainian pipelines are vital for this transit, as roughly a third of Russian gas flows through these lines.
- Should war break out, how much gas Russia will be willing to push through the system remains a huge risk and any damage to the infrastructure would only compound matters. Offsetting this, winter is coming to an end and temperatures thus far have been fairly mild. This might help to dull any natural gas spikes that may ensue.
- On the oil side, Russia is also a large supplier to the EU. Inventories are sitting at a 7-year low and spare capacity at the moment appears to be limited. Obviously, conflict could very well push oil prices higher. But there is a fair amount of geopolitical risk premium already embedded in spot prices. Regardless, any de-escalation would see a retreat in prices but still settle in at elevated equilibrium levels given the current supply constraints.
- What’s the impact from higher energy prices? This would act as a drag on consumers’ disposable income. Accumulated savings and government interventions on higher prices thus far have cushioned the blow in Europe. But the longer these price pressures persist, the more the risk of a strong adverse impact will linger.
- Earnings would also take a hit. Industrials, Materials and Consumer-related plays would have to absorb these higher costs which would crimp margins.
However, since the 2014 Crimean conflict, European banks have reduced exposure to Russia significantly. Austrian banks have the largest exposure to Russia with a share of roughly 4.6% of gross domestic product (GDP) exposure to the Federation. French and Italian banks have about 1% of their respective GDPs in exposure to Russia. These linkages seem somewhat confined, and the broader adverse impact would likely manifest through the growth channel rather than the credit channel.
Central Banks to the Rescue?
Maybe. Maybe not. Central banks could certainly err on the side of caution regarding interest hikes moving forward. But this would be a pause at best, and at worst be ignored. However, we doubt this ultimately deters rate hikes in the end.
- Case in point – the US 2-year Treasury Note rose from a close on Friday (Feb. 18) of 1.469% to 1.589% (Feb. 23). With that yield pushing higher, it certainly is not pricing in a shift in Fed policy resulting from Russian aggression. If anything, further upward pressure on oil prices could exacerbate global central banks’ inflation concerns.
- On the European Central Bank (ECB) front, higher energy prices certainly could result in a growth shock and downside risks to that outlook going forward. Would the ECB tighten into a growth shock? Doubtful. But who knows.
China/Taiwan is a very different situation. China isn’t looking for any deals. They want complete control over Taiwan. Also, back in 1982, the Reagan administration made “Six Assurances” to Taiwan, a set of commitments the US made to Taiwan and its leaders. Of course, governments make commitments to each other all the time, and some are ignored and some are observed. Assurances with a capital “A” are certainly much more significant than assurances with a lowercase “a”. The point here is that the US will be much more willing to get involved with support for Taiwan than it would for Ukraine.
What About the Sanctions?
The Donbas region of Ukraine has largely been pro-Russia, with the vast majority of those living there carrying Russian passports. Russia has always had a military presence there – declaring this region an independent state obviously provides cover for an increased presence. So annexing this region was really a big yawn. Because of this, the definition of an incursion provides a slippery slope. And as a result, sanctions have been fairly superficial. These include:
- A ban on Russia sovereign debt (primary and not secondary) – US entities will be prohibited from directly financing Russian issuers.
- The 351 Russian Duma members and Russian elites have also been sanctioned (freeze of assets) as well as 27 other Russian officials.
- Russian banks – including VEB and Promsvyazbank – have been sanctioned and their debt has been blocked from trading on US and European markets. These banks are considered close to the Kremlin and the Russian military with more than $80 billion in assets.
- Germany has halted the process of certifying the Nord Stream 2 gas pipeline from Russia. Germany has taken a proactive step here in an attempt to solidify its control over this one. By controlling this process, Germany reduces the risk of the US sanctioning Nord Stream 2.
- Should the US sanction Nord Stream 2, this would leave the pipeline at the whim of US policy – Germany may or may not be able to get the US to roll back this move. With Germany moving first, they control the process and can ultimately dial up or down the certification process as needed. The cancellation of this makes no material difference to Germany or Europe – the pipeline is not yet active.
- Will Russia withhold supplies farther down the line? Should military escalation continue, Moscow could point to Germany being the first to interfere in the gas market for political reasons and thus retaliate.
- These sanctions/moves are modest ones as of the date when this was written (February 23, 2022). Should Russia escalate from here, expect increased pressure from the West.
- Recall that Russia has $630 billion in reserves. This is more than enough to service their debt obligations at the federal level. And with oil prices rising and China still a willing buyer, hard currency receipts will still be coming through the door.
- So far, any moves for sanctions have avoided the oil and gas sectors of Russia. These could remain off limits. For obvious reasons, sanctioning these sectors would only lead to higher energy prices – a situation that carries economic and political costs domestically here in the US and in Europe.
- SWIFT disconnection. SWIFT is a vast global messaging network used by banks and other institutions to rapidly and securely send and receive information, including money transfer instructions. This is the lifeblood for financial transactions to occur on the international scene. So, removal from this system effectively makes cross-border financial flows very difficult. Seeing that this system is not under US control, there appears to be limited support abroad to kick Russia off the system.
Geopolitical fears will likely take time to subside. The longer this situation lingers, the more the damage will resonate through investor confidence. It’s also important to consider that investor sentiment is already hovering near multi-year lows today. Nonetheless, couple this with lingering concerns over inflation and monetary policy and it’s easy to see some major price swings in the offing.
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