From Russia with Tanks Part II – What’s Next?
Two weeks ago, Russian forces invaded Ukraine, launching the largest military campaign in Europe since World War II. While the geopolitical ramifications of the invasion may not be known for years, the implications for the global economy and the financial markets will be felt much sooner.
As one might expect, the market dropped immediately the morning after the invasion began. However, it rebounded just as quickly, finishing up that first day. In fact, stocks have been relatively resilient the last two weeks. While this may seem surprising under the circumstances, it is a reminder of how quickly stock prices incorporate available information and how the market is always pricing in future expectations. The focus now shifts to what impact the war and economic and financial sanctions levied on Russia will have on the global economy, oil prices, and financial markets going forward. And what, if anything, should investors do with their portfolios?
- Economic and financial sanctions: The West promised tough sanctions on Russia should it invade Ukraine. Two measures target Russia’s financial system. One is to limit the Russian central bank’s access to over $600 billion in reserves held outside Russia. The other is to cut off Russian banks from the SWIFT financial network. SWIFT enables the transfer of money between banks to support global commerce. The goal of these moves is to cripple Russia financially, including Vladimir Putin and wealthy Russian families, by freezing financial assets and inhibiting the movement of money. These sanctions, if effective, will drive down the value of the Russian ruble (which has already happened), cause Russian inflation to spike, and hopefully, put Putin under immense internal political pressure.
In addition to financial sanctions, the West implemented export controls to block Russia from receiving semiconductors and other technology to severely impact Russia’s ability to modernize its military, aerospace industry, space program, shipping, and other industries. These controls did not originally affect Russia’s energy exports, although the U.S. did decide to ban the export of specific refining technologies, making it harder for Russia to modernize its oil refineries. However, just this week, the U.S. and the UK announced bans on imports of Russian oil and gas.
- Oil prices: Russia is the second-largest oil and natural gas producer as well as a major supplier of commodities such as fertilizer, wheat, and aluminum. Europe is particularly dependent on Russian energy. Fear that a prolonged conflict could lead to a disruption or complete halt in Russian oil exports pushed oil prices above $120/barrel and drove up European natural gas prices by 60%+ in the days following the invasion. The West faces a dilemma in that it wants to hit Russia where it hurts most (energy) but does not want to cause a big jump in oil prices, triggering higher global inflation and a possible worldwide economic slowdown. To offset the rise in oil prices, the U.S. and its allies agreed to release 60 million barrels of oil from strategic reserves.
- The economy and financial markets: Although it seems trivial to focus on the economic and financial impact of the conflict when the fate of Ukraine and its people hang in the balance, as investment advisors, we must consider what an extended conflict may mean for clients’ portfolios. At one extreme, an oil shock that drives inflation substantially higher could push the U.S. and other economies into recession. We might then see the type of stagflation experienced in the 1970s when OPEC cut off oil exports to the United States. While this is a risk, it is one with a low probability for several reasons. For one, the U.S. is much less dependent on Russian oil than it was on OPEC oil as we import a very minimal amount of oil and natural gas from Russia. Furthermore, the U.S. economy is a lot less reliant now than in the 1970s on energy to drive economic growth. Back then, it took 100 barrels of oil to generate every unit of GDP. Today, it takes less than 40 barrels. In addition, while gas has become more expensive, gas purchases represent a lesser proportion of U.S. household income today than even a decade ago. For instance, as the chart below illustrates, at current gas prices, the average U.S. worker can afford 7.9 gallons of gas for every hour worked. In 2013 (the last time oil prices reached triple digits per barrel), that same worker could afford 5 gallons of gas for every hour worked. Gas prices would have to increase another 50% from current levels for gas consumption to be as big a proportion of hourly income as it was in 2013.
Impact on Financial Markets
It is difficult to predict what will happen to financial markets in the short term. We know the market detests uncertainty. In the weeks leading up to the invasion, speculation around whether Putin would or would not invade caused stocks to sell-off. With that uncertainty lifted, the focus now becomes what a prolonged war will mean for returns. It is important to remember that prior to Russia’s invasion, the economic fundamentals were quite solid. The economy was growing, corporate earnings were good, interest rates were low, and job numbers were strong. None of that has changed now that Russian boots are on the ground. Certainly, in the weeks and months ahead, the West will face tough decisions regarding sanctions and further intervention. At the same time, the Federal Reserve will weigh the impact of those decisions on its shifting monetary policy. These are all risks that are likely to cause the market to be volatile in both directions.
The Russian Market
It is also interesting to note the impact on Russian financial markets. The Moscow stock exchange shut down for days. Two major index providers, MSCI and FTSE, removed Russian equities from their widely tracked emerging market indexes. Global companies such as BP, Shell, Exxon, Apple, Disney, Nike, and many others have either pulled out of Russia completely or suspended doing business there. While Russia is a relatively large component of the emerging market space from an economic standpoint, it plays a very small role in most emerging market equity portfolios. The fund we currently use had less than 1% of its portfolio invested in Russian equities before the crisis – none of which traded directly on the Russian stock exchange. That already very small exposure has essentially now been eliminated.
We Have Seen This Before
While every geopolitical crisis is different, there is consistency in how the markets perform following the advent of the crisis. Just about every year, we are confronted with unexpected events that might make one hesitant to invest or to stay invested. As the chart below shows, if one had known in advance about any of these events and chosen to sit on the sidelines, the opportunity cost would have been tremendous. A successful investment strategy is long-term focused, well-diversified, and non-reactive to short-term disruptions in the market. If anything, those pullbacks create opportunities to rebalance and tax-loss harvest, if appropriate.
Source: JP Morgan, Fact Set.  Cumulative total returns for a 60/40 portfolio are calculated from December 31 of the year prior to February 23, 2022. The portfolio is characterized as 60% invested in the S&P 500 index and 40% invested in high-quality global fixed income, represented by the Barclays Global Aggregate index. The portfolio is rebalanced annually. Data is as of February 23, 2022.
While we cannot predict when this crisis will end or what the human and material costs will be, we continue to be confident that our investment strategy is built to weather the storm. Please do not hesitate to reach out to your wealth management team with any questions or concerns.
As a member of the Investment Committee, Matt is instrumental in developing BDF’s overall investment strategy. Matt received his Bachelor of Science in Economics with concentrations in accounting and finance from the Wharton School of the University of Pennsylvania and his MBA in finance and strategic management from the University of Chicago Booth School of Business.