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INVESTMENT INSIGHT: RUSSIA & UKRAINE

by | Apr 1, 2022

Setting the Scene—Why Russia/Ukraine Concerns Matter

The Russian invasion of Ukraine is increasingly fluid and potentially harrowing. As investors—not as politicians or news reporters—we thought some perspective on the investing implications from a multi-asset perspective is warranted.

As a preamble, it is important to disclaim we are advocates of long-term investing. Inherently, we believe it is important in situations such as this to keep one’s bearings and not lose a long-term perspective. Unsettling headlines can lead to fear, which in turn can lead to sub-optimal decisions, which in turn can undermine long-term return objectives. Goal-based investing is the answer.

At the same time, we can’t just ignore risks. As fundamental investors, we believe it is important to assess and understand any potential long-term market implications from this type of potential conflict. While there are certain impacts that are relatively clear and mostly well understood by market participants, there are also other less obvious impacts that need to be assessed

Furthermore, it is important to be alert and prepared during periods of uncertainty, as short-term fluctuations and volatility can uncover potentially significant investment opportunities at attractive valuations.

First-Level Impacts: Energy Markets Must be a Primary Focus

It is fairly clear that the Russia/Ukraine conflict has potentially significant energy-market implications. This is particularly true in European natural-gas markets, which are supplied mostly by way of imports from Russia. Russia also is a significant player in global oil markets, and speculation around the price impact from curtailed supply out of Russia has already embedded a “geopolitical risk premium” into oil prices.

As well, to the extent the sanctions imposed increase in severity, there could be significant incremental friction imposed upon an already-stressed global supply chain, which in turn could exert more significant inflationary pressures in other commodities that Russia supplies to the world. Between Russia and Ukraine, the two countries account for 25% of global wheat exports, and Ukraine is responsible for 13% of corn exports, so food inflation is a major risk. Additionally, Russia is the largest producer of ammonium nitrate and is a large exporter of palladium, platinum, and aluminum.

In an environment of rising global inflation, this increases the pressure on central banks globally to tighten monetary policy. Specifically, central banks may feel compelled to act in order to dampen inflationary pressures, most likely through increases in policy rates. In the event that rates reset higher, this generally represents a headwind for fixed-income investments—all else being equal—particularly in developed markets.

Equity markets, while certainly volatile of late, will be impacted differently. As sanctions are now imposed on Russia by western countries at scale, the Russian economy and equity market could weaken further. We’ve already seen the MSCI Russia Index (a favored index for Russian stocks) fall by more than 60% year-to-date in 2022.

Elsewhere, the prospect of accelerating inflation in developed-market economies may come with cost-of capital implications, especially for longer-duration growth equities (such as the big technology names with lofty valuations), which may not yet be fully priced in. And, of course, there are potential beneficiaries, such as global energy companies who could benefit from an extended period of elevated energy prices.

Energy Market Implications Will be Felt Most in Europe

Russia (and more broadly the other so-called “Commonwealth of Independent States,” or CIS) is an important supplier of energy to the world. With production of 14.7 million barrels per day, Russia met 16% of the world’s petroleum (oil and refined products) needs and on this basis is the world’s second largest producer behind the United States. At 858 billion cubic meters per day, Russia produces 22% of the world’s natural gas, and again is the world’s second-largest producer, behind the United States.

Perhaps most importantly, Russia looms largest as an energy supplier to Europe. Including other CIS countries, Russia supplied approximately 43% of Europe’s imported oil and petroleum products, as well as around 56% of Europe’s imported natural-gas supply, in 2020. Moreover, approximately 33% of gas supplied by Russia to Europe is transported through Ukraine. The key message here is simple: when conflict bubbles up between Russia and Ukraine, energy markets take note.

The trouble spot is clearly Europe. The region has become increasingly reliant on imported energy supply as a combination of policy initiatives, regulatory-driven supply curtailments and a lack of investment in local conventional-energy supply growth. Together, this has conspired to cause local energy supply to shrink in recent years. With global-energy prices substantially rising through 2021 and into 2022, the aforementioned local-supply issues in Europe served to exacerbate the local vulnerabilities, leading to substantially more rapid increases in European energy prices than those experienced globally.

Inflation Thoughts: It Could Get Worse Before It Gets Better

Severe sanctions are already being imposed against Russia, but this could get worse—and may add to preexisting inflation pressures. The potential sanction list below is far from exhaustive, but it could foreseeably include sanctioning the three largest Russian banks (VTB, Sberbank, and Gazprombank), removing Russia from SWIFT, or sanctioning exports of critical technology and members of Putin’s inner circle, among others.

Russia’s response to these sanctions could prompt an increased risk of inflation. This is likely to include disruption of critical energy, food, and industrial commodities. By some estimates, these disruptions could add up to 2% extra headline inflation in developed markets, most notably in Europe. This, in turn, could potentially serve to give further impetus to accelerated tightening of monetary policy, given the inflationary backdrop and already hawkish signals from central banks. On the other hand, there is a chance that rate hikes could be delayed to buffer against economic uncertainty, plus fiscal spending could be loosened to cushion the blow to real incomes.

Digging into some of the details, we see that the energy component of the inflation calculation varies from region to region. In the U.S. consumer price index (CPI), as an example, energy price changes accounted for 7.5% of the index in late 20218 . That doesn’t seem all that significant; however, we can see that when energy prices rise substantially, as they did in the January 2022 CPI report, this can significantly influence the overall inflation number. In this report, energy-price increases of over 25% year-over-year contributed close to a 2% CPI change, which was over a quarter of the 7.5% year-over year change in the index.

A Final Takeaway for Concerned Clients

Finally, we’d like to close with a word on the benefits of long-term investing. Looking back through prior geopolitical events, we find that staying invested in line with your goals often gives you the highest probability of investing success. That’s not to say the risks aren’t worthy of your attention—they definitely are—but carrying a diversified portfolio of undervalued assets should hold you in good stead over your investing lifetime.

In this sense, the classic British admonition emanating from World War II, “Keep calm and carry on,” seems quite appropriate to us as we view the investment case regarding the Russia-Ukraine conflict. A long-term approach to investing can help guard against unwise decisions overly informed by short-term fears. A fundamental, valuation-driven approach can help assess the opportunity set and potentially identify attractive opportunities.