- Our thoughts are with Ukraine
- Long-term consequences
- Lessons from the past
Our thoughts are with Ukraine
There’s little we can add to the facts about what’s happening on the ground in Ukraine. Global media coverage has brought the devastation of this invasion into our living rooms in an unprecedented manner. We’re shocked by the destruction brought upon Ukrainian civilians, and are in awe of their bravery as they band together to fight an army superior in strength and weaponry. We still hope for a quick resolution to the conflict, but regardless of the outcome, Russia’s actions will reverberate through the world for years to come.
Geopolitical events are complex to navigate as the range of outcomes and consequences are wide. For instance, we really don’t know Putin’s endgame. Annexation of part of the Ukraine? Regime change with a puppet government? Further actions across Europe? All are possible.
By most accounts, the Russian soldiers are being caught off guard by the resistance they’ve encountered. Military failure is a possibility. Either way, the sheer magnitude and robustness of the sanctions placed on Russia is a surprise to many observers, and the pain of these sanctions will be felt most acutely by the average Russian citizen.
There will be an economic impact from this war felt across the globe. Energy and agriculture are big exports from the two countries, and we’re seeing commodity prices rise substantially. This acts as a tax on consumers. If a gas tank used to cost $80 to fill and it now costs $100, that’s $20 extra spent for no additional value. Over the course of a year, these costs add up.
Many economists are now increasing their forecast for inflation and lowering their estimates for growth this year in North America, and even more so in Europe. We were expecting a reopening bump in economic growth and inflation normalizing in the back half of the year. It’s more likely now that economic growth will slow more towards pre-COVID-19 levels, and inflation will be much stickier than originally forecast.
The short term is unpredictable, but if we think about the longer term, some consequences come into sight:
- Russia is currently uninvestable. Foreign capital from the West will not flow into Russia again until investors are satisfied that the regime is rational and stable. It’s just too risky. The Russian stock market is severely impaired. Russian bonds could default, with Western bond holders facing the lowest recoveries. Western companies on the ground are leaving and abandoning physical investments.
- Energy spending will increase. The world is undergoing an energy transition from fossil fuels to renewables in a bid to address climate change. Although this transition will take decades, many stakeholders have been treating it as if the transition will happen much sooner. Governments have imposed taxes on traditional energy and investors have been punishing firms that seek to grow production.
With Russia being a key source of oil and gas for European energy needs, we can expect the continent to seek to diversify. In general, it’s likely that countries will start to care about not just the carbon footprint of their energy imports, but also where the commodity is coming from.
When it comes to oil, for instance, wealthy countries tend to import from poor countries (Figure 1) which are often also associated with poor human rights records. Expect this to change, at least on the margins.
Figure 1: Crude oil importers and exporters
- A new arms race. We may not see a return to cold war spending on armaments, but we are likely to see an increase. The military has been a source of budget savings in many countries. With a more aggressive Russia, expect military budgets to rise globally. Germany, among others, has already signalled this.
- Russia moves even closer to China. Russia needs China more than ever. Russia’s banking system has been severely interrupted by the West. USD reserves have been seized. China is now their financial lifeline. It should be noted that while Russia needs China, China does not have the same degree of need for Russia.
Lessons from the past
At times like these, it’s tempting to draw conclusions and to act. It may even be tempting to sell everything, for instance, to avoid the volatility. However, history shows us that although geopolitical conflicts are devastating for people and can cause market corrections, these corrections have often been short lived.
For instance, three months after the Japanese bombed Pearl Harbour the S&P 500 was down over 12% but had fully recovered nine months later. A year after North Korea had invaded South Korea in 1950, to start the Korean War, the S&P 500 was up over 11%. To the markets, what matters most is the underlying economy and, at this point, we still don’t see a recession on the horizon – especially in North America.
It may also be tempting to make a big bet. For instance, oil is going higher so buying energy stocks may seem like a layup. Why not go all in? Many thought the same thing about selling stocks with the advent of COVID-19 in March 2020. With the economy moving into a recession, why own stocks? Global markets rapidly rebounded with many markets reaching new highs in a relatively short period of time. The market has a way of humbling those who forget lessons of the past and, as always, diversification and long-term investing remain the safest option for most investors.
Sources: worldstopexports.com, BMO Investment Strategy Group, FactSet, Bloomberg