On February 24th, 2022, Russian forces invaded Ukraine. Dubbed a “special military operation” by Russian President Vladimir Putin, this incursion into Ukraine has devolved into a war between two sovereign nations, the first seen on the European continent since the onset of World War II. Given the brutal combat, unprecedented sanctions, and most importantly, the humanitarian catastrophe on the ground, we want to provide our perspective with a special newsletter. In this newsletter, we will dive into the origins of this conflict, the impact on markets, and how this tragedy may impact client portfolios.
For most of the period since the breakup of the USSR in 1991, Ukraine and Russia have had relatively cordial relations. Unlike other former Soviet republics or satellite states in Eastern Europe, Ukraine did not seriously pursue NATO or EU memberships. However, this ambivalence towards integration with NATO and the EU transformed into a broad desire to join both blocs after the 2014 Russian annexation of Crimea. By February of 2022, this Ukrainian support for joining Western institutions appeared too much for Russia to stomach. While President Putin claimed to free the Ukrainian people of a pro-Nazi and pro-criminal regime as a justification for war, experts believe that the Russian invasion of Ukraine is an overt attempt to bring its closest neighbor back into line with Moscow’s interests.
Immediately after the invasion, Western nations slapped Russia with the largest retaliatory sanctions package ever seen. Notable elements of this package included the freezing of $630 billion in foreign exchange held by the Russian Central Bank, suspension of the Nord Stream 2 gas pipeline, and the denial of access for Russia’s largest banks to SWIFT, the international payment network. In addition, the U.S., EU, and UK denied their airspace to Russian flights and froze the assets of many of the so-called Russian oligarchs holding property in their jurisdictions. Finally, scores of Western companies like Apple, McDonald’s, Ford, and most of the private oil majors have also announced they will suspend Russian operations in an act known as self-sanctioning. Quickly after sanctions were announced, the MOEX Russian stock market index crashed 33% before trading was suspended and the Russian Rouble dropped in value to less than one penny.
Taken together, these actions and the numerous other less publicized sanctions have had a profound effect on the Russian, Ukrainian, and world economies. Paramount in this discussion are the effects of an economically isolated Russia. While only the 11th largest economy in terms of nominal GDP, Russia has an outsized influence in several key commodity markets including energy, grains, metals, and other essential inputs. Russia is the world’s second largest exporter of oil, behind Saudi Arabia, and the world’s largest exporter of natural gas. As oil and natural gas are global commodities, any disruption to Russian production (see Western energy companies’ self-sanctions) or Russian distribution (like threats to ban the import of Russian hydrocarbons, as implemented in the U.S.) will cause prices of these commodities to rise in the short-term. And rise they did, with benchmark Brent crude up moderately at the onset of the conflict, though these gains have since reversed. This volatility is in addition to the already massive spikes we have seen in oil and natural gas prices year to date, at 29.35% and 22.52%, respectively. Because energy is the base of almost all aspects of economic activity, these price increases are likely to permeate every part of our daily lives. According to AAA, we are already seeing some of this with average gasoline prices jumping more than 24% in the past month.
While Russian energy takes the headlines, there are several other key input commodities that are affected by this war. Grain production is one major concern, as both Ukraine and Russia are grain export powerhouses. Interestingly (given its frigid geography), Russia leads the world in wheat exports, with about 17.6% of the global market. Ukraine ranks fifth with 8% market share. Not surprisingly, due to the war between these two top grain producers, wheat prices have soared. Per the Chicago Board of Trade, wheat futures prices shot up 50.46% from the onset of the invasion through March 7th. Beyond cereals, basic metals prices are also impacted by this conflict. Russia is a major player in the production of nickel, ranking third globally behind Indonesia and the Philippines. This commodity is critical in a variety of industrial applications, notably stainless steel and high-performance batteries (such as those found in electric vehicles).
Per Bloomberg, commodity brokers were so concerned about the wartime volatility of nickel that on March 8th the London Metal Exchange halted all nickel trading on its exchange after the price of nickel contracts increased 250% in just two days. Taken together, these wide-ranging and varied commodity spikes are already translating into higher inflation in the U.S., with the March 10th CPI print at 7.9%, the highest level since January 1982.
Unfortunately, we expect inflation to continue for at least several more quarters due to both the existing cyclical factors and now the conflict in Ukraine.
For many investors, the main financial concerns of this conflict are the impacts of heightened market volatility, increased inflation, and interest rate hikes. However, direct exposure to Russian assets should not be as much of a concern. CWAG’s exposure to Russian equities is extremely limited in our strategies. Our exposure comes from the following international funds: MFS International Diversification Fund (MDIJX), Vanguard All-World Ex-US ETF (VEU), Vanguard FTSE Emerging Markets ETF (VWO) and the Baron Emerging Markets Fund (BEXIX). Taken together, even in our most aggressive all-equity mutual fund strategy, Russian companies comprise only .2238% of the overall portfolio.
Regardless of this limited exposure to Russian securities, we understand that there is considerable concern amongst our clients given the global market volatility. There are no immediate answers to how the markets will react in the short-term, especially given the fog of war. However, it is in times like these that we realize the value of the time- tested strategy that CWAG employs. Below are useful graphics recently released by Vanguard and BlackRock that show how equity markets have performed during troubling geopolitical events. While there may be pain in the short-run, markets generally get their footing relatively quickly and ultimately recover in the long term.
In fact, despite the grim news coming out of Ukraine, U.S. investors are seeing little additional blowback from the war with regards to domestic stock market performance. From the onset of the war on February 24th through March 16th, the S&P 500 has returned a positive 3.42% over that period. This positive return may be surprising, given that the S&P 500 is down year to date by 9.85%. What this suggests, however, is that markets were concerned even before the war started.
Top concerns for the market this year are the related issues of sustained inflation and interest rate hikes. As mentioned above, inflation has proven to be far stickier than previously thought. With supply chains still struggling to
achieve pre-COVID levels of distribution and commodity prices spiking on the events in Russia and Ukraine, monetary policy is increasingly looking like the main avenue left to combat inflation. Indeed, we saw this with the .25% rate hike after the March 16th FOMC meeting. J.P. Morgan Asset Management predicts a further 6-7 rate hikes this year. With less easy-money, stock market prices may react negatively. Add in a geopolitical shock on top of this sustained inflation and likely further rate hikes, and it is no surprise that markets have appeared spooked this year. Despite these headwinds, as history has shown us time and again, the best way to fight this volatility is by sticking with your investment plan and riding out the temporary market turbulence. In time, these declines in markets will appear to be mere blips over the long run. This can clearly be seen in the chart from Fidelity below.
In closing, this newsletter is oriented towards the economic consequences of recent events, but it is critical to not forget the real suffering in Ukraine. It is tragic to see the pain inflicted upon the Ukrainian people fighting for their freedom against a foreign aggressor. While we are blessed to be far removed from any of the physical horrors of the conflict, we are not removed from the global financial implications of war. The destabilizing events of the Russian invasion of Ukraine can be felt in both continued inflation as well as in stock market volatility. Despite these concerns, CWAG continues to believe that the time-tested strategy of diversified asset allocation and a buy-and-hold time frame will provide investors with the best long-term results. Given the fluidity and complexity of the situation in Ukraine, we recognize it is an ever-changing situation, so we encourage you to reach out to us if you have questions about your own individual portfolio.
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