by Kenneth J. Entenmann
As the world watches the events unfold in Ukraine, it goes without saying that what we are witnessing is tragic and the human toll is something that cannot be understated. Military action always brings uncertainty, and it is difficult to assess the full extent of the situation while it is unfolding. The Russia-Ukraine conflict is no exception, and it has resulted in stunning market volatility.
However, strictly from an investment and economic perspective, geopolitical events rarely cause major bear markets or recessions. The markets tend to view them like natural disasters. That is, they are highly regionalized, they cause significant loss of property and life, but tend to be short-lived.
Historically, dating back to the Iraq invasion of Kuwait in 1990, there have been nine global military “interventions.” The time period from the onset of the event and the market bottom ranges from 0 days to 70 days. For example, the market bottomed out 10 days after the 9/11 attack in 2001. The average decline in the S&P 500 is -6.9 percent. Importantly, the markets tend to recover quickly.
The average one-month return after the bottom is 2.2 percent, the three-month return is 5.4 percent and the one-year return is 13.5 percent. Like all geopolitical events, the Russia-Ukraine conflict is impossible to predict. That said, it is likely to follow history’s pattern for a few reasons.
First, when we look at the global economy as a whole, the Russian and Ukrainian economies are small. The U.S. economy is the largest in the world at $21.4 trillion and nearly 25 percent of the total global GDP. By comparison, the Russian GDP is $1.7 trillion and 1.94 percent of global GDP while Ukraine’s GDP is estimated to be $156 billion.
Both economies are commodity driven. Economic sanctions will certainly impact the Russian economy, perhaps reducing it by as much as 50 percent, making it an even smaller part of global GDP. Therefore, regardless of the duration and extent of the situation, it is unlikely to have a major impact on global economic growth. However, it certainly will be disruptive and negative for growth in the short-term. Russia is a significant energy producer, and it is not surprising oil prices have jumped dramatically. The Wheat, Corn, Palladium and Nickel markets will be impacted as well.
The conflict will be more damaging to Europe than the U.S. as it is estimated that less than 1 percent of the total revenue of the S&P 500 is derived in Russia. In addition, U.S. energy companies have limited exposure to Russia and divested after the Russian Crimea annexation in 2014. However, Europe has a deeper trading partnership in the region. European energy companies have several joint ventures in Russia, many of which they have been forced to divest this week. Nearly 40 percent of all energy consumed in the European Union comes from Russia.
Many have argued that this energy dependence was a great enabler of Russia in this conflict. Indeed, there have yet to be sanctions placed on the Russian energy industry, amplifying Europe’s dependence.
Overall, the global markets have been stunningly volatile but remarkably resilient. The equity markets were already weak prior to the conflict and recent events have accelerated that weakness. Nonetheless, the markets seem to be concluding this conflict will be short and contained.
The net effect will bring modestly slower global economic growth and higher inflation. Oil prices are trading well over $100 per barrel and will lead to higher inflation in the short-term. Concerning, but not catastrophic.
Indeed, slower global economic growth may come with a surprising, unintended consequence. Slower growth could slow the pace of inflation, reducing the need for the Federal Reserve Bank to aggressively raise interest rates. In fact, interest rates have declined since the start of the conflict. The yield of the 10-year Treasury note has declined from nearly 2 percent to 1.80 percent since the onset of the conflict. The futures market for Fed Funds has removed the prospect of 50 basis point rate hike in March.
While expectations still call for the first rate hike in March, this situation gives the Federal Reserve an excuse to take a slower approach to monetary policy changes.
It is too early to assess the duration and long-term impact of the Russian-Ukraine situation. Given the history of market reaction to military interventions and the current circumstances, it is likely that global economic growth will slow, but not plummet. Inflation will remain more persistent, if not accelerate in the near-term. However, it is likely to ease in the long-run but remain well above the Fed’s target level of 2 percent.
Market volatility will reign as emotions swing with the headlines. Most importantly, the prospect of an economic recession in the United States is small.
From an investment perspective, recent market volatility demonstrates the need for a long-term strategy that doesn’t waver in times like these. Whenever the markets experience strong equity returns—like we’ve had the last 2 years—it’s tempting to give in to chasing easy money in hot areas of the market. While a long-term strategy with proper diversification can be viewed as “old school” and a drag on performance, the Russian-Ukraine conflict provides yet another example of how swift and sudden events can disrupt the latest trends.
As I’ve already noted, investors have been rewarded for sticking with forward-looking, steady investment plans during times of military interventions. So, even after the weak start to 2022, the recent geopolitical turbulence, and the S&P 500 index -8.70 percent decline (as of March 2), there is reason to be concerned but not panicked. Instead, stay patient, stay invested, and turn any desire for action toward a more humanitarian response.