A little background
Russia launched military attacks against Ukraine. That was after Russian President Putin recognized two regions of Ukraine as separate and sovereign territories. Putin’s actions were almost universally condemned as an unprovoked act of war and a violation of international law. The U.S., the U.K., and the European Union were quick to impose sanctions against individuals connected to Putin and Russian banks.
How bad can it get and how long can it last?
Putin says he has a list of grievances against the West, including expanding the North Atlantic Treaty Organization (NATO) too close to his country’s borders. There may be room for a diplomatic de-escalation, but it is a fluid situation and is unclear what would constitute success from any party’s perspective. If Russia aims to “demilitarize” Ukraine, it is hard to understand how Ukraine could be considered a sovereign country. If Putin is trying to turn Ukraine into a vassal state, that could lead to a protracted conflict. It will be necessary to watch the West’s response and then Putin’s reaction. The Russian response might not be localized to Ukraine since Russia has engaged in cyberattacks in the past and those can go global.
The market reaction
Unsurprisingly, equity markets sold off and oil prices spiked higher. The S&P 500 Index started entering into a correction (a 10% or more decline from a peak) back on January 3 with the Federal Reserve (Fed) becoming more hawkish. Things spiraled lower as the Russia-Ukraine situation escalated. Russia is a big supplier of oil and natural gas, so those prices have jumped higher. Ukraine is a major exporter of agricultural products and those prices have also shot higher. Credit spreads have widened while Treasury yields have dipped lower as fears have risen. The parts of the equity market that have done the worst are emerging markets (which include Russia), Europe (due to its dependence on Russian gas), and consumer discretionary. With high energy prices, inflation pressures are compounded and those higher prices could be a drag on growth as consumers need to reallocate their budgets toward higher energy prices.
Major trading partners of Russia stand to be greatly affected by war or any follow up sanctions imposed as a result.
Lessons from the past
Spasms of fear tend to be short-lived. Fears drive equity prices lower, but if reality doesn’t end up as bad as feared, things can turn very quickly. During the Cuban Missile Crisis in 1962, the S&P 500 Index had a drawdown of 6.3%. During the Soviet invasion of Afghanistan in 1979, the drawdown was 8.8%. During the Gulf War in 1990, the S&P 500 Index fell 15.9%. When Russia invaded Crimea in 2014, the market was down 1.4%. The recoveries were often aggressive and happened just when things looked their worst. If there’s a lesson from the past, it’s that it’s hard if not impossible to time turns in markets that are driven by these geopolitical issues. Diversification and patience seem to be the proper way to navigate through these situations.
What to do now?
These market spasms can be opportunities to reallocate toward target long-term allocations in line with long-term goals. However, there are some risks. Will this be short-lived? If so, we could get a rebound quickly, so acting quickly to reallocate to target could be important. But this could be long-lived, which means acting quickly could lead to short-term regret—things could get worse. That’s where taking a long view is important. We think it is also important to be adaptable as the narrative and outlook evolve.
The sentiment and oil price shock is a negative shock to global growth and makes inflationary pressures more acute. Central banks like the Fed should be able to take this as an opportunity to postpone rate hikes or reduce the prospective sizes of hikes. There is a lot that can happen between now and the next Federal Open Market Committee meeting, so it is premature to jump to a conclusion about how the Fed might respond, but it does tilt things in favor of being less hawkish.
In the past 10 to 20 years, geopolitical conflicts have tended to be a buying opportunity for credit as many conflicts remained localized and tended to be relatively short-lived. It is premature to draw similar conclusions at this point as the tenor and depth of this conflict are hardly clear. Inflation is already a problem, which seriously complicates the central bank response function. This conflict strikes at the heart of NATO and could set the precedent for other countries to pursue similar strategies. As such, we are being opportunistic in fixed income markets, but within prudent bounds.
In equities, we are similarly opportunistic within bounds. At the end of the day, we have to ask what this means for the cash-flow-generating potential of companies we follow. For some, it matters a lot. Energy companies may get a windfall with high oil prices. Companies that have to compete for consumer dollars—a larger chunk of which is going to gas—could face short-term headwinds. We have been watching how this situation has been unfolding for weeks. Our fundamental equity teams, with their deep knowledge of the companies and issuers they invest in, along with our systematic teams who are focused on allocating to risks they believe are well compensated, are in a good position to help investors navigate this.
Our investment risk management function has been continuously monitoring firm-wide exposures to all Russian-related securities since the initial Obama-era sanctions were enacted in 2014. We increased our scrutiny of these exposures last year when the Biden administration highlighted its concerns regarding Russia’s military buildup in the region. Our main focus is on the most likely paths of expansion of 2014 sanctions, including prohibitions around Russian sovereign debt. We have expanded our reviews to parts of Eastern Europe and to European banks with significant exposure there.
In the face of this rapidly developing situation, we encourage investors to calmly assess their overall exposures to emerging risks and opportunities as they arise. We at Allspring will be standing by your side.