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Russia has both recognized as independent and sent “peace keeping” troops into the two Ukrainian break-away provinces of Donetsk and Luhansk. While troubling in its own right, the bigger geopolitical concern is that these actions represent the first step of a Russian campaign to invade Ukraine. It is unclear whether Putin’s intentions – and resolve to endure increasingly stiff economic sanctions – go that far or whether viable diplomatic alternatives remain that satisfy Russia’s purported desire to constrict NATO’s influence near its borders.
Following the Russia-Ukraine news, the S&P 500 index fell just over 1% on the day. That relatively modest decline, however, was already following a poor performance the prior week driven by the anticipation of such an event. The U.S. oil benchmark, West Texas Intermediate (WTI), closed over 1% on the day to above $92/barrel, and the international benchmark, Brent Crude Oil, closed nearly 2% to greater than $97/barrel. Natural gas prices in Europe saw an even bigger increase as Russia is a major exporter of the commodity to Europe.
The US, UK, and EU are all responding with economic sanctions on Russia. So far, the most biting of these is from the EU which include halting certification of the Nord Stream 2 natural gas pipeline from Russia to Germany. Additionally, the EU is reportedly preparing broad-ranging sanctions on Russian parliament members and restrictions on Russia’s access to financial services and capital markets in Europe. Overall, NATO unity looks significant.
In economic terms, the largest risk from further escalation is concentrated in Europe which could experience even stiffer energy prices at a time when inflation is already uncomfortably high. Rising prices in global commodity and energy markets would also have an inflationary effect in the U.S. and around the globe. In extreme scenarios, increased inflation pressures could lead the Fed to an even greater degree of policy tightening. Certain emerging markets such as China are also highly dependent on energy imports which could add to the country’s existing headwinds. Our recommended equity exposure that is overweight U.S. markets and underweight international markets still looks best positioned. Within the U.S., our recommended overweight to small caps reflects the considerably better valuation in that space which we continue to believe will play out favorably over time. Real estate could also provide a hedge to other equity positions if inflation stays high, but interest rate expectations do not increase substantially.
The Russia-Ukraine crisis is unlikely to resolve in short order. Whatever the next step, Putin’s hand is likely strengthened by steadily moving more troops into the Russia-backed regions of Eastern Ukraine. Perhaps only then will diplomatic negotiations begin in earnest. The U.S. and Europe still have very stiff economic sanctions available such as cutting off Russia from the SWIFT international payment system and imposing harsh export controls and financial market restrictions. Russia is certainly not a pushover or a stranger to hardships, but our belief is that the extreme outcome of a full-scale Russian invasion of Ukraine is still not the most likely scenario considering the painful economic measures that would loom.
Repositioning around geopolitical developments is especially challenging when the desired end state – in this case for Russia – is unclear. Lasting, globally damaging economic and market scenarios are likely confined to the most extreme outcomes of the Russia-Ukraine crisis. While uncertainty is high, we still believe the primary drivers of equity markets for the year will be the Fed, inflation, and earnings growth.
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