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UPDATE ON RUSSIA-UKRAINE CRISIS, PART II

Dave Donabedian, CFA

March 02, 2022

By CIBC Private Wealth Chief Investment Officer David L. Donabedian, CFA

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Russia’s invasion of Ukraine on February 24 represents the largest land invasion in Europe since World War II. The geopolitical fallout will have both short- and long-term consequences. We encourage you to view the accompanying webinar (To access the webinar, please reach out to a member of your CIBC Private Wealth team for the password), recorded on March 1, for a full analysis of the military and geopolitical implications of the conflict.

For financial assets, the invasion has introduced enormous uncertainty. Despite this, many segments of the capital markets have been relatively stable. In fact, the S&P 500 actually rose a bit in the four trading sessions following the invasion. And while US stocks have held up better than those in Europe (for obvious reasons), bond returns have also been positive—namely government securities perceived as safe havens, but corporate credits also rallied in price. Of course, this is only half the story.

Prior to the actual invasion, equity prices around the world had fallen significantly since the beginning of the year. In the US, both the S&P 500 and Nasdaq indices reached correction territory (down 10% from their previous highs). Some of this weakness was concern over negative developments regarding Russia’s intentions, but we believe an even bigger factor was the highest inflation readings in 40 years and concern that the Federal Reserve (Fed) and other central banks could reverse course and tighten monetary policy as a result.
 
The asset class that has been consistently positive both before and after the invasion is commodities, as investors seek inflation hedges. Further, given Russia’s importance as an exporter of key commodities, prices for energy, agricultural products and industrial metals have risen due to concerns about potential supply shortages. Most obviously, the price of oil crossed above $100/barrel, nearly doubling from a year ago.1 

In times of uncertainty, it is a good idea to focus on what we do know instead of pondering what we don’t. We know that Ukraine is not a member of the North Atlantic Treaty Organization (NATO); therefore, NATO members have no obligation to militarily defend the country. We also know that President Joe Biden and European leaders have stated repeatedly that they will not engage in direct military confrontation to defend Ukraine. Furthermore, Ukraine is a low-impact economy on the global stage, with gross domestic product smaller than the state of Louisiana.2 While Russia is a massive country of 144 million people, its economy is only one-thirteenth the size of the United States’ economy.3 Trade links between Russia and the US are also limited. (The US does more trade with Chile than with Russia.4)

It is also important to put this crisis in the context of others over the years. In a study of 18 geopolitical and financial crises since 1940, after an initial decline, the S&P 500 stabilized fairly quickly, and was higher a year later two-thirds of the time (see chart on the next page). In other words, reacting to geopolitical events by disrupting a well-constructed portfolio—with plans to reestablish it “when the coast is clear”—is a strategy that often backfires.

Crisis reaction—highly unpredictable (and short)

Analyzing S&P 500 reaction to 18 geopolitical or financials system shocks…

Market direction

Day of

1 month later

3 months later

1 year later

S&P 500 up

4

10

11

12

S&P 500 down

14

8

7

6

Median return

-2.5%

+0.4%

+3.3%

+6.7%

Source: Strategas. Events include Germany invades France, Pearl Harbor, JFK assassination, Penn Central bankruptcy, oil embargo, President Nixon resigns, Continental Illinois bailout, 1987 stock market crash, Iraq invades Kuwait, Soros breaks Bank of England, First World Trade Center bombing, Asian financial crisis, U.S.S. Cole Yemen bombing, 9/11 terror attacks, Iraq War, Bear Stearns collapse, Lehman Brothers collapse and BREXIT.

The Russian invasion of Ukraine is a serious geopolitical issue that may become more serious. We are monitoring events closely, but it is not a time for “fearless forecasts” due to the wide range of possible outcomes. Instead, we will be evaluating events and their impact on important drivers of financial asset prices, such as economic growth, inflation, monetary policy and market liquidity. 

We believe the most likely catalysts to change the outlook for both growth and inflation are commodity prices—energy, in particular. As mentioned previously, energy prices already skyrocketed in reaction to potential supply threats, and we will be watching closely to see if the ratcheting up of sanctions eventually leads to a cutoff of Russian energy exports to Europe. At this time, that would seem self-defeating for both sides. Economic sanctions are hitting Russia hard already, and energy exports are its largest remaining source of cash flow from abroad. Europe relies on Russia for roughly a quarter of its oil and more than a third of its natural gas.5 

If Russia turns off the spigots, it will more than likely exacerbate the already high rates of inflation plaguing Western economies. Additionally, higher energy prices act as a tax, leaving less discretionary income for consumers and businesses to spend elsewhere. Thus, it would raise the risk of recession, especially in Europe. We believe the US and Canada would be somewhat more insulated due to strong domestic production of energy. However, it would likely stoke already high inflation readings and slow what have been impressive economic expansions in both countries.

Accelerating inflation and flagging economic growth (i.e., stagflation) is a central banker’s nightmare. The Russia-Ukraine conflict presents risks to both the growth and inflation outlooks, making the policy decisions of the world’s central banks more challenging. Prior to the conflict, there was a nearly universal belief that the Fed would raise interest rates at its March 16 meeting. Futures markets still show that as the most likely outcome, but the probability has come down significantly. In short, the conflict—particularly if it is prolonged and sparks a further spiraling of commodity prices—raises the possibility of the Fed and other central banks making policy mistakes in the months ahead. 

In summary, geopolitical and macroeconomic risks rose, and financial asset prices have adjusted accordingly. Going forward, our focus will be less on the headlines and more on how developments impact daily economic and financial outcomes via interest rates, corporate earnings and confidence in the investment environment. 

We will continue to monitor and keep investors apprised of the evolving geopolitical situation between Ukraine and Russia. If you have any questions, please do not hesitate to contact a member of your CIBC Private Wealth team.