Russia Invades Ukraine - What Does it Mean for Markets?

“Volatility is the price we pay to build wealth.” – Office of the CIO, Beacon Pointe Advisors

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The situation in Ukraine has taken a dark turn with the Russian invasion
Markets have continuously digested the possibility of a Russian invasion for much of the last 30 days – this is therefore not a big surprise
The initial reaction to the invasion was “risk off” and stock and commodity markets declined, Treasuries and gold rallied
Markets are settling down, but the situation is fluid and subject to change
Our portfolios are built to withstand bouts of geopolitical volatility like this

The military outcome in Ukraine is a foregone conclusion – the country has been invaded by a superior Russian force from the North, East, and South, and the overmatched Ukrainian armed forces cannot stop them. The Russian military expenditure budget is ten times that of the Ukrainian government, and the Ukrainians are outnumbered in terms of armed forces by 3:1, tanks, and armored vehicles by 5:1. Furthermore, the United States and the European powers are not sufficiently incentivized to put the necessary troops on the ground to stop it – neither is obligated to do so by formal treaty. So far, the courageous Ukrainian response has been to fight, and casualties are mounting. Martial law has been declared.

To avoid a further escalation, the response from the West will be primarily economic. Sanctions will be tightened on Russian industry and banks (including Sberbank and VEB) and “FOP”, or “Friends of Putin”, but they may not do sufficient damage to the Russian economy until and if the Russians are cut off from SWIFT, the international bank payment processing system. This is the economic version of the “nuclear option” and would effectively isolate the country economically. Taking this step would harm both friend and foe and won’t be taken lightly. The Russians were NOT cut off from SWIFT in 2014 when they annexed Crimea and accelerated the support of separatists in the Donbas. Additional sanctions – including SWIFT removal – would negatively impact Russia AND many Western countries, notably Germany and the United States. Retaliatory sanctions from Russia are a foregone conclusion, further disrupting supplies of commodities and putting upward pressure on inflation. The Biden administration does not want to see gas prices in the U.S. go any higher given his approval rating and upcoming mid-term elections. The Western response to the conflict will not be costless, either economically or politically.

We hope and expect that much (but sadly not all) of the fighting will take place in “cyberspace” and be over swiftly – we should be able to avoid a prolonged conventional military conflict. Cyber tactics such as denial of internet service, electric grid and satellite interruptions to disrupt military command and control and weaken institutions will be sufficient to pave the way for regime change. There will be some considerable loss of life and property if the Ukraine army puts up a spirited fight to defend the heartland, but it will ultimately prove futile. The Ukrainian government will make a humanitarian and political decision to avoid unnecessary loss of life, or the Russians will soon force an abdication of the government in Kyiv. In either case, the most likely outcome is regime change in coming days.

Putin wasn’t subtle about his goals – they are well understood by geopolitical analysts and clearly articulated in his recent speech, where he said, “I would like to emphasize again that Ukraine is not just a neighboring country for us. It is an inalienable part of our own history, culture and spiritual space”. This is of course hogwash but provides the pretense for pursuing the real goal – to restore some measure of the Iron Curtain and reverse, to the extent possible, the dissolution of the U.S.S.R. that occurred on December 31, 1991. In 2005 he said, “The collapse of the Soviet empire ‘was the greatest geopolitical catastrophe of the century’.” Every foreign policy decision Putin has taken has been made in the context of increasing the buffer between Moscow and the West. He even mentioned it in his first speech as Russian Premier in 1999.

Ukraine is the biggest prize in the grand strategy to reestablish Russian hegemony within the space of the former Soviet Union. But Ukraine appears to be as far as he can go – the other former Soviet Bloc countries (Poland, the Baltics, Czech Republic, Romania, Bulgaria) are all members of NATO. If any of these countries are attacked by Russia, Article 5 would be triggered – ALL NATO members are bound by mutual defense treaty to respond to ANY member that comes under attack. This would precipitate World War III. Putin is a bully, but not a madman.

The market situation is fluid. Global stocks were initially down overnight 3-5% but have since recovered. Traders are unwinding equity volatility bets, signaling things may settle down from here – there is a TON of bad news priced in at the levels seen earlier in the trading day. U.S. Treasuries yields have rallied (prices higher, yields lower) – we saw 10-year yields as low as 1.84% overnight but they are now 1.92%. West Texas Intermediate (WTI) Oil was briefly over $100 ($100.54 at the peak, up as high as +10%, now up +7%). Brent Crude Oil was as high as $105.80/bbl, now $103.75). Natural Gas has seen a similar trajectory. Gold prices were near $1,980 (up 4% and peaking at $1,974.34), but now trades at $1,928 or +1.5% higher in the past 2 days. Wheat is at a nine-year high at $9.26/bu, up 10% – recall Ukraine was known as the “Empire’s breadbasket” in Tsarist times and there is fear of wheat supply disruptions.

Russian financial assets got destroyed overnight and in today’s Europe trading – the Ruble was down -10% in two days and -16% YTD. The MOEX (the Moscow stock index) was down -45% today but has recovered slightly to down just -34%. The Russian economy is relatively small – the country is really a “commodity superstore with nukes”, and that makes it both less significant in global growth terms (the economy is 1/2 the size of California’s) AND very impactful in terms of overall geopolitical risk and effect on commodity prices. The Russian government and the central bank have planned ahead to blunt the effect of sanctions and taken steps to insulate the economy and financial markets. They have issued more local currency debt and built substantial currency reserves. They will find buyers for their energy and other exports – the economy will stumble but not collapse. At least, that is Putin’s calculus.

We recommended that clients move closer to Risk Neutral in January as valuations became stretched and compensation for risk declined in a world of “Peaks” – peak monetary and fiscal policy, peak economic activity – and increasing geopolitical risks (Russia/Ukraine, China/Taiwan, Iran nuclear deal). With inflation at very elevated levels, the Fed’s ability to step in and support markets by easing monetary policy is much reduced, and therefore the downside to stocks is higher. They will continue to attempt interest rate normalization by raising rates and reducing the balance sheet in coming months if the economy and risk markets let them. The U.S. stock market has already adjusted substantially and was down intraday -13% from the January 3rd peak – in correction territory. But we are only back to levels last seen in June 2021, and up 87% since March 2020. The recent drawdown is not enough to put the Fed on hold.

During times like these, it is important to remember that volatility is the price investors pay for building wealth, and that our portfolios are built to withstand these bouts of volatility. As long-term investors we would NOT be looking to reduce risk at these levels. Clients should feel confident that the longer-term themes and theses we have articulated – “Financial Repression” and “Inflation Rates and Rotation” – remain intact, and that geopolitical risks exacerbate trends already in place, but are generally not the catalyst for a new trend.

Russia Invades Ukraine – What Does it Mean for Markets?

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