LEVATUS Q & A | Ukraine, Putin and Investment Strategy | The Factors that Matter

While the current geopolitical questions around Ukraine and Russia are complex, the central investment impact may be more straightforward.

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Conditions around the Russian invasion of Ukraine are complex, dangerous, and rapidly changing. The range of potential outcomes from an investment perspective are wide, given the path forward could take many directions. As the situation unfolds, additional clarity on items like the following will help to shed light on the depth of the impact to global markets.

·         Length of the conflict

·         Severity of sanctions; impact on global supply and supply chains

·         Escalation risks; global cyber warfare

·         Commodity price spikes; inflation

This note answers a range of client questions about the here and now,  potential outcomes and portfolio implications. If this conflict is short-lived, as was the case with Georgia in 2008, the negative impact of the crisis may be contained. If the conflict is more drawn out, deeply negative outcomes are possible.  

What is happening in Ukraine, and what does history tell us about how this will impact markets?

Russian President Vladimir Putin ordered troops into two pro-Russian, regions of eastern Ukraine on Monday (2/21/22) and this morning (2/24/22) launched a full-scale invasion. Conflict between Russian backed separatists and Ukrainian troops in this region have been a constant since 2014, with tens of thousands of lives lost. Today’s invasion takes this war to a dangerous new phase. The invasion has escalated the situation rapidly to one of the worst-case scenarios envisioned by the West.

While the situation is fluid we believe the following factors are critical from a market perspective:

·         Severity of sanctions

·         Longevity of conflict

·         Global escalation to a cyber war

Previous military wars such as Afghanistan and Iraq had a muted medium-term impact on markets. This is because the major impact was geopolitical. This time the path may be different because of the inflationary backdrop that existed before the conflict began and because Russia and Ukraine provide a significant amount of core commodities such as oil, natural gas, wheat, nickel, and other metals. These commodities are critical to everyday life and are central inputs in a range of components, such as semi-conductors and batteries.  The lack of policy flexibility at central banks to support markets in the face of disruption is also at a different point than it has been historically. This is a function of existing inflation and previous support programs.

With all this, the range of potential outcomes has become much wider than historical precedents, with the risk of stagflation (the worst outcome for financial markets) becoming more significant than it has been. A more prolonged conflict and more severe sanctions will increase this risk, while a shorter conflict with less severe sanctions will reduce the near-term risks.

What brought us to this point?

Over the years there have been many written and oral promises made that have been broken, both by the West and Russia. After German reunification Western leaders  promised not to expand NATO beyond East Germany, and they have. Under the Budapest Memorandum of 1994 Russia’s leaders promised not to invade Ukraine in exchange for Ukraine giving up its nuclear weapons, but they have. Vladimir Putin’s rhetoric has centered on the security risk created by the expansion of NATO, while his actions today make clear his bigger ambition of recreating the Russian empire.

How could the conflict affect my investments in the near term?

In our view the most significant market impact of the conflict in Ukraine will be transmitted via inflation.  Within the context of global liquidity conditions that are already contracting, additional inflationary pressures that accelerate the upward trajectory of interest rates create new and substantial risks. Much will depend on how long the conflict persists. Security selection in growth assets should reflect the risk that inflationary pressures continue to mount at the same time economic activity slows.

One potential offsetting factor to the upward pressure on energy prices in the near term would be a new agreement with Iran, as this would increase oil supply. Negotiations on this agreement are ongoing. It will be important to monitor progress in the weeks ahead

How will this conflict impact already high and rising inflation? What does this mean for portfolios?

Upward price pressures on oil, wheat, nickel, and other commodities exported from Russia and Ukraine will continue. This is inflationary and will keep upward pressure on interest rates and central bank policy. Within Funding portfolios, a laddered bond portfolio is well positioned to take advantage of rising rates.

Additional supply and supply chain bottlenecks may also emerge because of the conflict, as sanctions are put into place. This could add additional upward pressure on prices and also constrain available goods inputs which in turn would put a damper on growth. Portfolio positioning in quality companies with pricing power provides a defense against rising prices. These companies are best positioned to pass along additional costs, and while not immune to market volatility  are also best positioned to take advantage of opportunities created by that volatility.

What could some bigger picture effects be?

There are many potential long-term implications of the current conflict, with the range of potential outcomes quite wide.

·         Higher core inflation is quite negative for income inequality, as rising prices hits low wage earners the hardest. This creates long term structural risks to society and the economy.

·         At the end of the day this conflict may have a positive impact by bringing the EU closer together,  which will be a long-term positive for Europe.

·         The steady march away from globalization will have persistent inflationary implications.

·         A shift in geopolitical power away from the tenets of rules and diplomacy would increase the likelihood and frequency of periods of global instability.

Where does this leave us?

We think it is a mistake to assume that the market impact of this conflict will be short term and fleeting, as most other recent conflicts have been. In other words, buying the dip may not be the right strategy. Previous conflicts have had mainly a geopolitical impact, versus an economic one.  The current inflation backdrop creates a somewhat different set up, as does the size and importance of Russia as a major global supplier of commodities.

Economies, businesses, and assets already susceptible to the ongoing negative impact of inflation and higher interest rates set up to be the most effected by an intense and prolonged conflict in Ukraine. In these circumstances, a portfolio of quality companies, some dry powder to take advantage of market volatility, and a disciplined portfolio construction framework, continue to best serve our clients’ interests.   

Near term sentiment has become extremely negative already, so there could be a rebound from this extreme positioning. We have already seen the beginnings of this in today’s trading. Whether this translates into a more positive medium-term backdrop will very much depend on the inflationary impact of the conflict, as impacted by - how long the conflict persists, how deep sanctions are, and central banks’ response to rising inflation in the context of geopolitical instability.

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ABOUT THE AUTHOR

Susan Dahl is a seasoned executive, female leader and dedicated client advisor with over twenty-five years of international and domestic investment experience. Susan writes on topics such as long term investment growth and where to find it, the power of female leadership, and the intersection of investment and tax strategy. She is known for her work on investment process design for private wealth clients, as well as her development of a research based approach to financial advisory service delivery; an innovative approach that addresses quality of life in specific and tangible ways. A deep and diverse background that extends from global investing to risk management to process development and planning, has laid the groundwork for an advisory solution that asks more of wealth. She shares some her most recent work in a talk for TEDx, Can Happy Make You Money?

ABOUT THE AUTHOR

Keith Savard has more than 40 years of economic/finance research and investment experience in the United States and overseas. He has worked as a staff member at the Board of Governors of the Federal Reserve System and as an international economist at the U.S. Department of State. A solid background in macroeconomic analysis and financial regulatory and monetary policy issues, combined with sovereign and credit risk skills, has enabled Keith to offer investors actionable top-down investment strategies and expertise facilitating a broad-range of asset allocation decisions. His deep knowledge and understanding of emerging markets, gained through extensive travel and meetings with cabinet-level officials, company CEOs and local investors, affords opportunities to invest confidently beyond the United States.

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