Russian Invasion of Ukraine: Potential Market Impact
The Russian invasion of Ukraine has cast a pall on global markets and forced investors to consider a level of geopolitical risk not seen in more than a generation. As Russian President Vladimir Putin has taken the unfortunate approach of seeking to expand his sphere of control through military force, a human tragedy is now in progress for the world to view and, as expected, this has evoked economic sanctions upon Russia from the United States and Western allies. While this situation is highly fluid and subject to change on short notice, we believe investors should take the following into account:
From a global macroeconomic standpoint, we view the overall scenario taking place as creating additional inflationary pressure. This is due to Russia’s status as the world’s third-largest producer of oil and second largest of natural gas. As Russia’s supply of oil and natural gas becomes constrained globally, either through diversion to its military or through incremental attempts from Western nations to move elsewhere, this will likely continue to further increase already rising worldwide energy prices.
At this point we do not see Russia’s military advance into Ukraine, nor the sanctions imposed on it by the U.S. and European nations, as being materially negative to U.S. economic growth. Despite the chaos being inflicted by Putin, we believe pent-up consumer demand likely to be unleashed in the U.S. as COVID-19 potentially moves from pandemic to endemic status can still drive approximately 3% gross domestic product growth in CY 2022, though this pace is likely to be back weighted into the second half of the year. We also see a strong probability corporate earnings growth in the US (S&P 500® net operating earnings growth) can reach double digits or higher in CY 2022 and CY 2023, setting up stocks for total returns commensurate with such earnings growth.
The initial sanctions being imposed on Russia by the U.S. and its allies have involved economic and financial criteria only. These sanctions have included restricting business with Russia’s largest banks, prohibiting the ownership and exchange trading of Russian sovereign debt, and, most recently, the exclusion of certain large Russian banks from the Society for Worldwide Interbank Financial Telecommunications, or SWIFT, the world’s most important messaging system and facilitator of payments and financial transactions within the international banking system. Despite the tough and aggressive nature of these financial sanctions, we view them as more punitive than preventative and unlikely to deter Putin from Russia’s cross-border aggression.
While these U.S.-led sanctions are strict and aggressive from a financial perspective, they have to date not involved Russia’s large oil and gas exports. The likely reason for this is the current sanctions hold dual objectives — maximizing pain on Russia while minimizing any negative economic impacts on the U.S. and its allies. With U.S. inflation recently touching down at 7.5% (January consumer price index report) and Europe currently sourcing approximately 40% of its oil consumption from Russia, aiming sanctions directly at Russia’s energy exports is probably a bridge too far for the U.S. and Europe at this time.
A major wild card in the crisis now appears to be Ukraine’s initially stronger than expected military defense and national resistance. Combatting military aggression with economic sanctions unfortunately is not a strategy with a successful historical track record. Therefore, hopes of thwarting Russia’s advance into Ukraine will likely have to come from a higher toll of casualties and an extended time horizon of warfare inflicted by the Ukraine army and its citizens. Otherwise, the financial sanctions will probably only play a role in the post-war aftermath, perhaps somewhat dissuading Putin and Russia from further aggression and empire building, but unfortunately not changing the outcome in Ukraine.
Putin has escalated rhetoric to include the threat of nuclear weapons. On February 27, Putin announced he had put Russia’s nuclear deterrence forces on high alert, verbally going where no Russian leader had since the days of the Cuban missile crisis. This has led to speculation as to whether such language is a sign of frustration and perhaps a strategy to “escalate as a means to de-escalate,” or in a more drastic sense perhaps an indication of a dangerous dictator even more deranged than initially believed. While logic infers the former of these two scenarios, Putin’s words here should probably not be underestimated.
There are several ongoing developments of varying uncertainty that could potentially change the tide of the evolving crisis either favorably or unfavorably. These include, in addition to Ukraine’s military defense and further comments from Putin reversing or confirming his recent nuclear rhetoric, potential cyberattacks launched by or inflicted upon Russia, widespread political disagreement to Putin or social unrest within Russia, or a shift in sanctioning strategy against Russia targeting energy-based production or exports.
In the immediate days ahead, we expect to see more volatility in the U.S. and international equity and credit markets and a continuing move into safe-haven assets. This could result in temporarily declining U.S. Treasury bond yields though, we would caution such activity could prove short term in nature.
Putin and Russia have inflicted a degree of aggression and human suffering evoking those of the World War II and Cold War eras. While much remains to play out, both in terms of military conflict and its geopolitical aftermath, investors should strongly consider the context of this crisis within the entire global economy and overall opportunities within the equity and credit markets, which we continue to view favorably in the year ahead.
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