Ukraine: Implications for Investors

by | February 28, 2022

It is never easy to discuss matters of economics or finance in the context of war, death, human misery, and destruction. Yet even in our horror, we are powerless to suspend reality. Human resilience is based on our ability to adapt and endure, even in the most mundane fashion.

Nor can we pass moral judgment on markets, whether they are for financial instruments or ordinary goods and services. Markets are not animate, even if they express human needs, desires, and emotions. Markets are amoral. That’s true even when they react to immoral brutality.

What, then, should investors consider as potential near- and long-term implications of Russia’s invasion of Ukraine?

First, let’s consider some of the more durable implications.

In launching an unprovoked attack on a sovereign European country and democracy, Russia is likely to face long-term diplomatic, trade, financial and economic consequences. So long as Russia is governed by Vladimir Putin or individuals with motives akin to his, it will be ostracized and separated from the ability to engage in global markets for many goods and services, including most investment instruments.

The notion of BRICS—Brazil, Russia, India, and China—as the secular drivers of global economic growth and investment returns long ago lost much of its cache. Now, irrespective of the outlooks for the other three, Russia will be excluded from any such investment thesis. Russian government debt and significant chunks of its corporate debt and equity securities have become off limits for global investors. That’s partly because of US and European sanctions, but also because fiduciary considerations (‘governance’) will not permit many institutional and private investors from considering Russian securities as eligible financial holdings. That fact will only change when Putin and his followers are no longer in power.

The Russian invasion of Ukraine will also lead to a significant re-think of global security, including energy security. Russia is the third largest producer of energy in the world, the most important provider of natural gas to western Europe, and a leading global supplier of other commodities. Ukraine is also one of the world’s three great ‘bread baskets’, a major grain producer alongside North and South America. Assuming no quick resolution of the conflict, including a full withdrawal of Russian forces, buyers of energy and other natural resources from Russia and Ukraine will need to diversify their suppliers. 

The clearest example is in western Europe, where energy policy is likely to shift toward liquified natural gas (LNG) delivered from North America, the Middle East and Africa to reduce reliance on Russian pipeline supplies. Debates will grow about the need to re-think nuclear fission power and ultimately to explore the prospects for fusion. Wind, solar and energy conservation will also take on renewed interest.

Investors, of course, also want near-term clarity and abhor uncertainty. Until such time as warfare is replaced by diplomacy, markets will remain vulnerable to bouts of volatility. Late last week, markets recovered sharply, mostly on the belief that sanctions will not have adverse impacts on global economic activity. 

That remains to be seen. Complacency is not warranted.

It is an understatement to note that the situation is highly dynamic. In the past 24 hours, a range of western companies – airlines, oil producers, technology, spirit distributors, etc. – have stopped doing business with Russia. If the conflict escalates, this laudable trend will surely accelerate, ultimately reducing a broad range of corporate profits. 

If SWIFT access is withdrawn and the Russian central bank’s ability to prop up its currency undermined, which appears possible, a range of difficult outcomes will ensue. The Russian economy will be hobbled, the ruble will tumble, and there could even be a run on Russia’s banks. 

Russian energy exports may yet be disrupted, leading to higher prices for consumers and businesses everywhere. Moreover, if an act of war disrupted the flow of natural gas via Ukraine to Western Europe, price spikes would be compounded by distribution disruptions that could even risk European recession, with severe implications for US exporters.

Finally, the jump in global oil prices related to the conflict is akin to an adverse global aggregate supply shock. It simultaneously increases inflation and damages growth. 

That raises fundamental challenges for central banks.

Surging energy prices will compound already strong price increases in food, transportation, commodity, and industrial goods markets, where energy is an essential input. It seems likely that other prices—those captured in core measures of inflation—will also follow higher. After all, the pandemic, global supply chain disruptions, and accelerating demand have already unleashed strong increases in many wages and prices, which makes it now easier to pass along higher energy and commodity prices.

Yet those same price increases are likely to outstrip wage gains. And now that US consumers have drawn down savings to pre-pandemic levels, the risk is rising that lost purchasing power could slow consumption. That concern is greatest in Western Europe, where households and businesses are also confronted by the greatest security threat since World War II.

So, the question arises: Will central banks choose to fight inflation more vigorously, or will they instead focus on potential challenges to global growth?

Recent comments by Fed officials indicate that an overwhelming majority of Federal Open Market Committee (FOMC) members remain undeterred in their assessment that monetary policy must be tightened to slow inflation. Apparently, it will require a significant adverse shock—for example, a much larger decline in world equity markets and a corresponding reduction in investment and consumer spending—for the Federal Reserve to change course.

The calculus for the European Central Bank (ECB) is more problematic. Unlike an energy self-reliant US, Europe is dependent on Russian natural gas. The ECB must also be more attentive to potential weakness in consumer and business spending given uncertainty. It must also be prepared to respond to a massive supply shock in the event Russian energy supplies are disrupted. 

The bottom line is that while the Fed is freer to focus on fighting inflation, the ECB will proceed with greater caution.

Still, both central banks share a common focus on inflation expectations. If, already high inflation, now compounded by surging oil prices, results in a jump in long-term inflation expectations, both the Fed and ECB would tighten aggressively. Thankfully, that is not now the case. Market measures and surveys indicate that businesses, investors, and households continue to expect inflation to recede over time. But watch this space closely—few data points merit closer attention than inflation expectations.

All of which brings us to the investment implications of current events. History is kind to the idea that conflict-induced market selloffs are buying opportunities. In the terribly unfortunate language of Warren Buffet, investors should be prepared to buy when there is blood in the streets.

But we caution strongly against making decisions based on pithy statements. Even if, as we desperately hope, a ceasefire and peace can replace war in Ukraine, global equity market recoveries are apt to be brief and moderate. Here’s why.

First, market declines this year have been modest. A broad correction, defined as a 10% fall major equity indices, has not yet occurred.

Second, equity valuations remain above long-term averages despite clear signs of slowing earnings growth, high inflation, and a greater willingness by various central banks to tighten monetary policy. Historical comparisons, therefore, are naïve. Few of those oft-cited conflict episodes resembled today’s multi-faceted investment challenges. Markets may rebound if the war in Ukraine comes to an end, but the bounce is likely to be unimpressive.

It is far more likely that risk-adjusted returns have peaked. Gains will be more modest and volatility higher. That outcome is probable irrespective of how events in Ukraine play out.

Lastly, it is worth emphasizing that Russia’s invasion of Ukraine does not signal an end to global investing nor to emerging markets. Russia was never a major driver of globalization, whether in trade or finance. Its place in the BRICs acronym was always more out of convenience (BRICs sounds more solid than BICs) than it was fundamentally based. Asian and other dynamic emerging economies were always more important drivers of long-term global economic growth and investment returns. For most portfolios, the disappearance of Russia will hardly be felt. 

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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