Ukraine: The Investment Implications of a Loser’s Game

Financial markets sold off last week as investors worried about a possible Russian invasion of Ukraine.? Before engaging in any analysis of what this could mean for long-term investors, three broad points are worth emphasizing.

• First, we should recognize that war is almost always a loser’s game.? Whatever the goals of an invasion, its immediate effect would be in lives lost and ruined on both sides.
• Second, quite often, despite the toll in human misery, economies prosper and stocks rally over the course of a war.
• Third, wars evolve in unpredictable ways.? No one should assume that they can see all the impacts of a war at its outset.? For this reason, it makes sense to maintain a well-diversified portfolio.

The State of Play

Over the weekend, the U.S. National Security Advisor, Jake Sullivan, warned that, given the buildup of Russian forces on the Ukraine border, there was “…a distinct possibility that there will be a major military action very soon”.? Similarly ominous messages have been emanating from other western governments.?

The Russian government has denied any plan to invade Ukraine and the Ukrainian government has tried to downplay the threat.? However, initial Russian government denials of involvement in the takeover of Crimea in 2014 or of involvement in attacks on political leaders and journalists both in Ukraine and in Russia will make many doubt their current claims.? Moreover, regardless of the current stated intentions of the Russian government, it would not be difficult for President Putin to cobble together a pretext for an invasion in the days and weeks ahead.

The Russian government’s aggressive stance relative to Ukraine should be seen in the context of a proposal it published in mid-December which included a demand that Ukraine would never join NATO and that NATO would pull back forces from Eastern European countries that joined the alliance after May 1997.? In fact, there is no timeline for Ukraine to join NATO and NATO had committed not to place troops or nuclear weapons in newly-joining Eastern European countries prior to Russia’s annexation of Crimea.? Moreover, there is little reason to believe that NATO has any desire to encroach on Russian territory.

However, President Putin may be guided by a more personal and deeply nationalistic view of Russia’s rights.? In an interesting essay, following his annual “Direct Line” Q&A session with the Russian people last summer, he laid out a long historical argument that “Russians and Ukrainians were one people – a single whole” and that he was confident that “…true sovereignty of Ukraine is possible only in partnership with Russia”.

Possible Scenarios

If Putin’s worldview leads to a Russian invasion in the next few weeks, it could, of course, take multiple forms ranging from a further annexation of land in Eastern Ukraine to an attempt to takeover Kyiv and the entire country.? It should be noted, in this context, that Ukraine is a country of 44 million people, covering an area about the size of France.?

The consequences of this for the people of Ukraine would, of course, be horrible.? However, it would also likely have severely negative consequences for Russia.? While the Russian army could be expected to overcome their Ukrainian counterparts relatively quickly, occupying Ukraine in the long run would be a very different matter.? As Russia learned in Afghanistan and the U.S. learned in both Iraq and Afghanistan, holding foreign territory is harder than gaining it and Russia has limited economic resources to pursue a long-term occupation.

In addition, Russia would likely pay a steep economic price for such a move.? Apart from further economic sanctions, Europe could decide to boycott Russian gas or Russia could decide not to sell it.? This would undoubtedly be extremely difficult for Europe, which is already being hurt by high energy prices.? However, the long-term impact on Russia could be greater.? In the long run, Europe could find alternative energy sources and supplies.? Meanwhile, Russia might be pushed into a closer relationship with China as it scrambled to find markets for its fossil-fuel energy and, in any such a new alliance, China would clearly be the senior partner.

While a European recovery could see a temporary setback from a further energy shock, Russia could experience greater losses in the long run, as foreign capital shunned perceived political risks. That being said, there is clearly a limit to how far the West would go to punish Russia.? Russia remains a nuclear power, making it essential to avoid escalation without end.

Investment Implications

For financial markets, a Russian invasion of Ukraine could first be expected to boost global energy prices.? Russia supplies roughly a third of all the natural gas consumed in Europe and accounts for over 10% of global oil production.? Any shutdown or threatened shutdown of these supplies would push prices higher from today’s already elevated levels.

Other commodities could also see price surges in the event of a Russian invasion including wheat, aluminum and palladium.? It should be emphasized that all of this would occur at a time when commodity supplies are more stressed than they have been in a generation.? According to Bloomberg, more major commodity contracts are in backwardation today, (that is to say near-term prices are higher than prices for later delivery), than at any time since at least 1997.? Gold could also see at least a temporary boost as a traditional hedge against inflation and a traditional safe-haven asset.

However, beyond this obvious point, the implications of a Russian invasion become murkier.? It could lead to a flight to the safety of the U.S. dollar and long-term Treasuries, offsetting the inflationary impact of higher energy prices on overall inflation and interest rates.

In addition, while data due out this week on inflation and retail sales could strengthen the case for early and aggressive monetary tightening, the Federal Reserve might consider moving more cautiously in light of the potential for a war-related shock to business and consumer confidence.? That being said, consumers have proven resilient in the face of confidence shocks before and even a shock to business confidence might only erode some of the current huge pent-up demand for workers as the pandemic fades.

It also should be noted that markets have a habit of confounding expectations at times of crisis.? The S&P500 rose by 3% between the invasion of Kuwait in August 1990 and the allied victory in the following February.? Conversely, the market fell by 1% between the start of the Second Gulf War in March 2003 and the fall of Baghdad less than a month later.? History really doesn’t give us a guide as to how markets will react to any particular conflict.

However, history does teach us that wars are easier to get into than out of and that they usually have unpredictable consequences.? For this reason, while the world waits to see how Russia acts and the West reacts, investors would be well advised to maintain a defensive and well-diversified stance.?

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