Strategy blog: Ukraine - what are the risks?

Strategy team: Kevin Gardiner

Russia's intimidation of Ukraine has long been one of the most visible potential geopolitical flashpoints (Taiwan is another). It is starting to make investors nervous: do we need to rethink our macro advice?

Market timing is notoriously difficult, but we thought there were already good reasons for taking some profits on equities a fortnight ago. Expected interest rate increases have been brought forward, and stocks have been looking more expensive. But we have continued to favour stocks over bonds – and as yet, we do not think that developments around Ukraine warrant a further adjustment to long-term portfolios.

We can certainly imagine that they might. A seemingly demoralised West may lack confidence, but an invasion of a neighbouring sovereign state is not something it could watch without offering some form of logistical support at least – in contrast perhaps to its muted response to Russia's annexation of Crimea (previously part of Ukraine, but a disputed territory with closer ties to Russia) in 2014. The threat of wider conflict would increase the risk of economic disruption well beyond the likely surge in natural gas prices.

Monday was a dress rehearsal. Risk appetite would plunge and the "fear index" – the VIX, a measure of the cost of protecting stock portfolios – would surge. European stocks might lead the way down; "defensive" sectors and regions would outperform, doubtless alongside gold, oil and gas and the US dollar and yen (the franc less so perhaps).

Government bonds would surge as today's inflation risk is offset by the added demand for perceived "safe haven" assets. Despite soaring European natural gas prices, the inflation priced into long-dated government bonds might fall, not rise, as the lasting effect of the crisis might be viewed as deflationary.

Nonetheless, we doubt things will unfold in this way. Notwithstanding the political and humanitarian import, Russia's stance may not change the bigger investment picture, and negotiators still have wiggle room. The West has substantial economic leverage, despite Europe's dependence on Russian gas, and Russia needs to engage with the wider global economy (perhaps to a greater extent than China). The Russian economy is unbalanced, and its leaders' and oligarchs' overseas assets are exposed. Both sides may step back from the brink.

As we've noted in other contexts, capital markets are callously focused on the bottom lines of corporate cashflow and discount rates. If conflict is avoided, the impact of Russia's intimidation on the global economy and/or interest rate expectations may not be big or long-lasting enough to warrant a more substantial restructuring of portfolios. Meanwhile there is now something "in the price": some nervousness is already reflected in market indices.

Subsequent to this blog, we are issuing event-specific updates on this topic for clients only. We continue to review the situation in Ukraine and will provide ad-hoc updates on this topic as and when appropriate. For further information, please contact your client adviser.

Disclaimer

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