Today was a sad and historic day. In a bold and swift move without any direct trigger, Russian President Vladimir Putin ordered the invasion of Ukraine. Our thoughts are with the people of Ukraine during this difficult time. For investors, here are some short- and long-term ramifications:
1. Russia will be largely cut off from the Western financial system—and both Russia and the West will be okay with that.
Russia has become increasingly self-reliant, with exports concentrated in energy and other commodities. Though sanctions look set to cut-off the country from Western financing for its sovereign debt, Russia is running a budget surplus and does not need to issue debt.1 Additionally, the country has built up significant foreign exchange reserves and runs a current account surplus.2 If the prices of oil and other commodities stay elevated, as seems likely, these positive dynamics should continue and embolden Mr. Putin. The private sector in Russia (banks and corporates) will take the brunt of being cut off from Western economy, but that is clearly a risk that Mr. Putin is willing to take.
Western debt claims on Russia are fairly low and financial exposure is manageable. For example, U.S. banks’ claims on Russia (including its official sector, banking, and non-banking debt) amount to just 0.06% of U.S. GDP.3 For France, the equivalent figure is 0.86% of GDP, and for Germany 0.19% of GDP.4 So even if all those claims need to be written off, these economies can certainly absorb the shock. Also, revenue exposure to Russia for U.S.- and E.U.-based corporations is mostly in the single-digit range (with exception of oil and materials), although it varies by sector and company.5 Many Western asset managers and banks (and individuals) holding Russian assets will, however, suffer significant losses in portions of their portfolios.
2. Existing commodity flows will likely continue, but new business will be directed elsewhere
The West cannot immediately replace 10 million barrels of Russian oil at a time when Organisation for Economic Co-operation and Development (OECD) inventories are well below five-year averages and spare capacity remains limited elsewhere.6 However, we expect this conflict to trigger a long-term and permanent rethink of U.S. and E.U. energy policy. According to BP, the United States has 69 billion barrels of proven oil reserves.7 With rig count down 41% from 2018 levels, there is capacity to increase production.8 By the end of 2022, U.S. liquid natural gas (LNG) capacity is expected to increase to 11.4 billion cubic feet per day, and by 2024 it could rise to an estimated 16.3 billion.9 Europe can benefit from that. Boosting oil and LNG production should be prioritized and incentivized given the current backdrop. Additionally, today’s rally in U.S. clean energy shares appears to be connected to the invasion. An acceleration in the transition to clean energy is all but assured. Lithium (a critical component in batteries) can be mined in friendlier jurisdictions like Australia and Chile.
3. Cyber-attacks will become a more pervasive threat
Aside from limiting exports of energy and other commodities, cyber-attacks might become Russia’s preferred method of retaliation, targeting Western financial services, energy, and telecom infrastructure. The United States is said to be considering cyber-attacks of its own to hinder Russia’s military actions.10 Investing in cybersecurity will assume greater importance in a world where the desire to engage in ground war is low but the potential impact (and damage) of cyber-attacks can be great.
4. Tightening of financial conditions may change the course of Fed policy and present an opportunity to buy the dip
A study of prior military conflicts or airstrikes suggests that market reaction has generally been short-lived, resulting in an average drawdown of 5% but recovering in 47 days.11 As such, the sell-offs due to these confrontations presented buying opportunities for investors. We have previously argued that history may not repeat itself if the other source of uncertainty—the pace of U.S. rate hikes—continues to weigh on the market. However, given the extent of the ongoing deterioration in financial conditions and consumer and market sentiment it will be difficult for the U.S. Federal Reserve to be as hawkish as markets have expected.12 A pivot to more measured rate hikes may be the catalyst markets need to stabilize and rebound.
What should investors do? As previously highlighted, we would buy the dip in software and cybersecurity shares, employ a covered call strategy amid elevated volatility, and add to several areas we highlighted in our last post: Five Ideas for Uncertain Times.
(1) Source: Bloomberg, as of February 24, 2022.
(2) Source: Bloomberg, as of January 31, 2022.
(3) Source: iCapital, Bloomberg, International Monetary Fund, Bank for International Settlements, as of February 24, 2022.
(4) Source: Ibid.
(5) Source: JPMorgan Research, as of February 24, 2022
(6) Source: Bloomberg, as of February 24, 2022.
(7) Source: BP, Statistical Review of World Energy, 2021.
(8) Source: Bloomberg, as of February 24, 2022.
(9) Source: U.S. Energy Information Administration, as of December 9, 2021.
(10) Source: NBC News, as of February 24, 2022.
(11) Source: LPL Research, as of January 6, 2020
(12) Source: Goldman Sachs Investment Research, as of February 22, 2022.
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