War and Markets

Putin’s invasion of Ukraine is likely to have long term implications, not just on a geopolitical level, but also for markets. In this column, we examine how investors might be affected by the new war.

Last Thursday, Russian President Vladimir Putin ordered the invasion of Ukraine, resulting in what senior US defence officials have called ‘the largest conventional military attack that’s been seen since World War II’.

The war has already started to reshape the global political and military landscape, in particular in Europe where Germany has abandoned its long-standing policy of not supplying arms to countries in armed conflict.

The country also has announced significant increases in military spending, including the establishment of a €100 billion fund to boost the strength of its armed forces and raising its annual defence spend by half a per cent to two per cent of GDP.

Sweden, which hasn’t sent weapons to a country in armed conflict since the Soviet Union’s invasion of Finland in 1939, followed a similar move.

NATO also seems to have been given a new lease on life, despite Putin’s attempt to curb its activities. Already, Kosovo has asked for an accelerated membership of the pact, while offering the US to establish a permanent military base in the country. It is not unlikely that more countries will follow suit, including Sweden and Finland.

Questions have also been raised about how China will react to the current situation, especially in regards to its moves on Taiwan.

It is no secret that the Chinese government has raised the pressure on Taiwan to join the mainland. And although few people were predicting a hostile takeover of the island in the near future, the Ukrainian invasion might have emboldened China to opt for a military solution.

This is not merely pessimism. The day after the invasion of Ukraine started, the Chinese ambassador to the US, Qin Gang, tweeted:

“We are ready to realize peaceful reunification with utmost sincerity and efforts. “Taiwan independence” separatist forces are the biggest obstacle to China’s reunification. If they are allowed to go down the dangerous path, risks for tension will be heightened.”

But investors will also be directly affected by the invasion of Ukraine. The first signs were seen in the rise of gold and oil prices, while sanctions against Russia’s Central Bank ensured that Russian sovereign debt is now effectively untradable.

Safe and Not-so-safe Havens

The rise of the gold price is no surprise as the precious metal is seen by investors as a safe-haven asset.

What was surprising is that cryptocurrencies, sometimes hailed as digital gold, did not react in the same way. Many cryptocurrencies saw a steep decline in value on the day of the invasion, with Bitcoin losing almost 10 per cent that day.

Others were less convinced about the link to Thursday’s chain of events and pointed out that Bitcoin had been on a losing streak since mid-February and actually showed a recovery since Friday.

In an interesting twist, millions of dollars of cryptocurrencies have been donated to the Ukrainian government in an effort to support the war effort against Putin, creating quite a bit of activity around the digital asset.

Regular currency markets have also been heavily impacted as the sanctions on several Russian banks in regards to the SWIFT system, a network for international payments, saw investors abandon the currency.

On Monday, the Russian currency showed a decline of more than 40 per cent during the day, although it managed to contain the losses by close of business to 20 per cent. It is unclear what the impact of the fall of the rouble will be, but as market observers pointed out: the last time the rouble moved this much, Long Term Capital Management blew up.

Oil & Gas

The oil price was one of the first movers on the back of Putin’s declaration of war. The price moved higher on expectations there would be more demand for oil in the war effort, while supply might become restricted. But energy-related commodities more broadly are likely to increase in prices.

Questions have been raised whether Putin was expecting this, since Russia is a large exporter. Author Daniel Yergin, who won a Pulitzer for “The Prize: The Epic Quest for Oil, Money & Power,” raised this question in an interview with the New York Times’ DealBook

“The oil market always goes through cycles, but it’s just gone through the most violent cycle that I’ve ever studied — from negative prices less than two years ago to an incredibly tight market.

“Whether Putin calculated that or not, he chose a time when oil markets are really tight, gas markets are really tight, coal markets are really tight, and he’s a big exporter of all three. So he’s a beneficiary of it,” Yergin said.

The European dependence on oil and gas has also raised security issues, while some commentators go as far as to say these issues have been made worse by a move away from coal-fired power plants.

The Lowy Institute, however, believes that in the case of Australia the issue of energy security might spark an accelerated take-up of clean and renewable energy, since solar and wind are domestic energy sources.

Bonds

Another direct impact on markets were sanctions that specifically targeted Russia’s sovereign bonds. Canadian Prime Minister Justin Trudeau announced that Canadians will be banned from purchasing Russian sovereign debt.

But it seems few investors are interested in buying any of these assets anyway. S&P Global Ratings downgraded the bonds to junk status, while Moody’s put the bonds on review for a downgrade, which would also see them rated as junk if they did.

The sanctions could see investors scrambling to get out of Russian bonds, which will put further pressure on the rouble.

The pain of these sanctions will be felt by the many investors who have gone into emerging market bond index funds in recent years, since these funds, by their very design, can not underweight selective assets in the index. Russian bonds make up about 3 per cent of such indices, including of the JP Morgan Emerging Market Bond Index.

When sanctions were first mentioned as a response to the invasion, many skeptics labelled them as ‘too little, too late’. But in an unprecedented confluence of measures from both governments and businesses, real economic damage was inflicted in the space of only five days.

The European Union, supported by the United States, the United Kingdom, and Canada, decided to target Russia’s central bank with the aim of preventing it from using its large stock of foreign-exchange reserves intended to soften the blow of any sanctions. The measure is estimated to have put two thirds of Putin’s $600 billion war chest out of reach.

Meanwhile, BP and Shell walked away from their interests in the Russian energy sector. BP announced that it would divest a 20 per cent stake in state-owned Russian energy giant Rosneft, while Shell pulled out of joint ventures with Gazprom. Shell is also looking to abandon the Nord Stream 2 gas pipeline from Russia to Germany.

These measures come at significant losses to the companies, which seems to indicate a new attitude towards risk, especially reputational risk. Or as the New Yorker’s John Cassidy writes: “When even Europe’s oil barons abandon Russia and its vast energy reserves, it is evident that the geopolitical – and geoeconomic – map has been redrawn.”

Equities

The impact on equities is less clear. Market sell-offs on the back of armed conflict, or geopolitical events more broadly, haven’t lasted long in the past. This is partially because markets tend to look ahead.

So far, this has been the experience in the current conflict too. After a slump on Thursday, many markets recovered the following day and then some.

Russian majority state-owned multinational energy corporation Gazprom initially suffered a decline upon the declaration of war, but its share price has steadily clawed back territory, most likely on the back of rising oil and gas prices.

There will be impacts on selected companies. For example, Australian investors are subject to a black list, issued by DFAT, which names people and companies that they can’t invest in. Although it is likely that this list will be expanded in the light of the new sanctions, the list is relatively short and deals with niche entities.

The energy and financial services heavy domestic stock markets are in green territory for the month, but that trend was already in motion before the war started and the broad ASX 300 index is still recovering from the selloff last Thursday.

Longer term, the broader equity markets are unlikely to see a prolonged downturn on the back of the current situation in the Ukraine, although this could change if more European countries get drawn into a war with Putin.

The next few days will likely be crucial in this regard.

Wouter Klijn

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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.