For several weeks, the world anticipated a Russian invasion of Ukraine. A brazen, unprovoked invasion of an independent, sovereign nation seemed no longer possible in the modern era. Yet Mr. Putin has made his move in what is likely to be the most significant conflict in Europe since World War II.
Russia’s timing was certainly intended to deter as much western meddling as possible, forcing the US and European allies to carefully weigh how much economic pain is tolerable. Inflation is an irritating problem in the west. Another inflationary, energy-driven shock adds to existing political pressures.
Up until now, the financial markets had been laser-eyed on the Federal Reserve. Now, focus has shifted to geopolitics. Stocks, which had already touched correction territory in January, retested those levels in February. Global stocks are 7.8% below their recent highs. Energy stocks have benefited from higher oil and gas prices, while cyclical sectors lagged.
High quality bonds, namely US Treasuries, benefitted from safe-haven flows, reversing some of the year-to-date sell off. Inflation-protected bonds led the bond market as higher energy costs lifted inflation expectations.
While the invasion has led to turmoil in our financial markets, the reaction pales in comparison to the impact in Russia where the fallout from sanctions is crippling. So far, the Russian Ruble has declined 30% and is worth less than one penny. Russia restricted capital flight, and the Russian stock market fell over 30% since mid-February. While we are complaining about $3.50 gasoline, Russians are calling Zimbabwe wondering how many zeros to add to their currency.
How will this end? Will Putin stop at Ukraine? Is Putin crazy, or does he just want the world to believe he is? It is impossible to know what is going on inside Putin’s head. The impact of global sanctions on Russia is still uncertain, but the risk for the U.S. and Europe is that supply chains are further disrupted, and inflation pressures are exacerbated.
The stock market has historically weathered global conflict well. In past invasions, such as Korea in 1950, Kuwait in 1990, and the beginning of the Iraq war in 2003, the markets responded unfavorably in the first few days. But in each case, the S&P 500 gained more than 10% in the year following the invasion. Even during the Cold War, stocks averaged about 10% per year over the 40 years leading up to the collapse of the Soviet Union. Over time, markets adapt to the new, frightening risks and carry on.
What It All Means
Uncertainty is inherent to war, and financial markets are likely to remain volatile. War is precisely the low-probability event that markets have a difficult time anticipating. The rapid developments on sanctions, countersanctions, and other wartime efforts can spur knee-jerk reactions in financial market moves. Avoid shifting your portfolio too heavily toward the perceived winners in such a fluid situation. War evokes strong humanitarian or nationalistic emotions. Coupled with the dips and rips of financial markets, heightened emotions can cloud decision-making.
While the human toll is tragic, the conflict has created opportunities for those willing to take a long view. Global macro shocks often create risk which in the long term is rewarded. Broad market timing bets based on short-term forecasts for the next week, month, or year are likely to be wrong, and potentially costly if acted on. Taking advantage of new opportunities through strategic, diversified risk-taking will likely pay off.
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