Update on Ukraine-Russia Crisis

Dave Donabedian, CFA

February 23, 2022

A special commentary from our Chief Investment Officer

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The territorial dispute between Russia and Ukraine has been simmering for years but took a decidedly negative turn in the last 48 hours. After amassing about 190,000 troops1 near the Ukrainian border in recent weeks, Russian President Vladimir Putin escalated the crisis on Monday, February 21 by declaring in a speech to his country that “modern Ukraine was entirely created by Russia.”2 He then recognized eastern regions of Ukraine (the Donbas) bordering Russia as independent and sovereign states. On Tuesday, Russian troops and armored vehicles rolled into the Donbas under the guise of “peacekeeping.”2 President Joe Biden termed the actions to date an invasion. As a result, a variety of economic sanctions against Russia are being implemented by the US and European countries, with more likely to come in the days ahead.

Financial markets reacted to these events predictably—and fairly moderately. The S&P 500 fell 1.0% on Tuesday, and Treasury bond yields were roughly unchanged. Commodity prices rose on fears that supplies of energy, industrial metals and wheat could be constrained by the conflict.3

While the endgame of this conflict is unknown, it is clear that the best-case scenario didn’t happen. For those hopeful that Putin was just saber-rattling, events progressed beyond that. From here, the question remains whether there is a full-scale invasion of the country, a more limited incursion into additional portions of eastern Ukraine, or a consolidation of the areas of the Donbas already controlled by pro-Russian separatists. At this point, the last option would probably be viewed as a relief by financial markets, reminiscent of other moves by Russia in Crimea in 2014 and Georgia in 2008. However, the other two (more drastic) scenarios are quite possible.

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 (including the US) have no obligation to militarily defend the country. We also know that 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.4 While Russia is a massive country of 144 million people, its economy is only one-thirteenth the size of the United States’ economy.5 Trade links between Russia and the US are also limited. (The US does more trade with Chile than with Russia.6)

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 Exhibit 1). 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.

It is tempting to view the S&P 500’s 10% correction from its early January high as a direct result of the Ukraine crisis. We believe it has only been a secondary factor and that most of the volatility has been driven by high inflation and the resultant policy pivot by the Federal Reserve (Fed). The Russian incursion into Ukraine is a serious geopolitical issue that may become more serious. However, with a three- to six-month view, we believe that the pace of economic and earnings growth and the Fed’s efforts to arrest inflation will be bigger drivers of market behavior than events in Ukraine. One area of potential linkage between the Fed and the Ukraine crisis could be a further jump in commodity prices as sanctions lessen the global supply of Russian energy and metals. We will be evaluating closely whether this transpires and its potential impact on inflation.

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.