The Russia-Ukraine crisis seems to be fueled by Russia’s interest in neutralizing Ukraine’s ability to be an independent geopolitical actor, but the Ukrainian military response, Western sanctions and the ability to extract concessions in advance via diplomacy make any full-scale Russian invasion unlikely. Also, the absence of significant market moves beyond commodity and the capital markets of Russia and Ukraine suggests tail risk outcomes remain low probability events. In the event of an unlikely escalation that triggers broad sanctions, the main downside risk would be a late winter energy price spike that could affect Europe’s economic growth.
What are the market implications of Russia’s threat of invading Ukraine? It is important to separate geopolitical analysis from the odds and magnitude of financial market spill-overs in any given outcome.
We rarely have the luxury of possessing enough historical data points to evaluate the credibility of a combatant’s military threat. However, Russian President Vladimir Putin has largely governed for over two decades and has presided over numerous military interventions abroad to establish a few clear patterns. The 2008 invasion of Georgia, the 2014 takeover of Ukraine’s Crimea peninsula, the 2015-2017 intervention in Syria and the recent dispatch of troops to Belarus and Kazakhstan all provide a good set of empirical evidence.
This track record underlines that Russia uses force even when material risks are present but pursues a narrowly defined strategic goal while doing so. In Ukraine’s case, Mr. Putin has clearly spelled out his objective, which is to neutralize Ukraine’s ability to be an independent geopolitical actor.
Russia is embarking on this confrontation from an unprecedented position of economic strength. Since the Crimea invasion, it has pursued an orthodox macro policy mix that has delivered stronger external and fiscal balance sheets. While this has led to negative real income growth per capita over the past decade (something hard to sustain in a democracy), the policy fundamentals look very solid: FX reserves are near a 7-year high and not very far-off from all-time high levels (Figure 1).
Moreover, the composition of Russia’s FX reserves now has the lowest share of US dollars in the post-Soviet era. The share of FX loans in the banking system is also near all-time lows even if over 20% of loans are still issued in foreign currency. The government is largely running balanced budgets and public debt burden is low, both in gross as well as net terms due to the build-up of sovereign wealth. In particular, external debt is low and non-resident bondholders of government debt only make up about 20% of the investor base.
In contrast to both Russian determination and preparation, the United States (US) and most other NATO members neither view Ukraine as critical to their national security nor feel particularly well positioned for a protracted conflict in Eastern Europe. High energy prices, especially natural gas prices charged to European households, are an economic threat to post-pandemic recovery. Severe sanctions would have to curtail Russian oil and gas supply (over 40% of European Union’s (EU) gas imports), exacerbating the energy crisis. And finally, Germany just had the first change in leadership in 16 years, with an agenda that accords low priority to security beyond the EU’s external borders.
Overall, this is an asymmetric face-off between a well-prepared and determined Russia versus a US-led West that is neither well prepared nor has cohesive views on Ukraine’s strategic relevance. In addition, both the Ukrainian military response and Western sanctions would make any full-scale Russian invasion costly for Mr. Putin whose strategic goal is to restore Ukraine as a ‘buffer state’ with limited geopolitical independence, akin to most other former Soviet states (except Baltics). In this regard, a military invasion is only one path to achieving this goal. The Minsk Framework and other existing formats also offer a pathway toward an agreement but may require intermediate military steps to force a deal.
In sum, this asymmetry is ultimately more likely to produce a limited military escalation leading to a diplomatic outcome rather than unconstrained military escalations that may prompt severe Western sanctions.
First, the probability of large spill-over effects is low, which suggests that the widening of risk premia in commodity markets is not fully justified. Coupled with an improving supply/demand balance in crude oil, a gradual decline in energy prices in the spring time would coincide with the resolution of the Ukraine crisis. The same would apply to gold prices, particularly in an era of rising rates. Other metals with high Russian production share, such as palladium (up 12% since beginning of the crisis), could also see a retrenchment in prices.
Second, even a limited military confrontation or a diplomatic resolution would retain some of the discount applied to Ukrainian assets. The neutralization of the country’s westward orientation would probably lower long-term growth expectations and further hamper structural reforms. In contrast, the Russian ruble and other assets are likely to recover some of the recent drawdown once the crisis stabilizes.
Third, the absence of significant market moves beyond Russian and Ukrainian capital markets also reflects market confidence that tail risk outcomes (such as Western sanctions on Russian oil & gas trade) remain low probability events. Other trade links are unlikely to be meaningfully affected either. Even in a full-scale invasion scenario, it is more likely the West would focus on financial sanctions. The biggest potential spill-over would stem from the ban on secondary trading of Russian bonds, leading to the removal of Russian components from global emerging market (EM) indices. However, this would largely be a fleeting phenomenon that would trigger short-term volatility and could possibly lower bond yields in EM economies that would suddenly see a growth in share in indices.
In the event we are mistaken and conflict escalates and triggers broad sanctions, the main downside risk would be a late winter energy price spike at the cost of European economic growth, leading us to trim our overweight European equity position. Global sentiment may also take a hit with long duration bonds and safe-haven currencies benefiting from a flight to safety.
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