Ukraine-Russia Conflict: What You Should Know

Russia, previously the largest and most influential USSR member is trying to recreate history where Ukraine falls under their leadership. For centuries Ukraine was a part of Russia; since Catherine the Great of Russia annexed Ukraine in the 1700’s all the way until the early 1900’s when Ukraine fought for their independence. Ukraine unfortunately lost the battle and became a part of the Soviet Union (USSR) in the 1920’s.

Conflict between the two largest and strongest economies of the USSR continued to as recent as one generation ago where Joseph Stalin, Russia’s President at the time performed an ethnic cleansing of a country called Crimea (a small peninsula to the west of the Russia and south of Ukraine). All Crimean nationals were removed and Russians subsequently occupied the space on Stalin’s request. After Stalin’s death in 1953, the then Premier of the Soviet Union, Nikita Krushchev transferred Crimea to Ukraine in an attempt to warm the relationship between the two parties. In 1991 Ukraine gained their Independence as the Soviet Union dissolved and Crimea stayed under Ukraine’s umbrella. This was short lived after Russia invaded Crimea in 2014 and took control once more.

The history lesson provides some context as to why much of Russia feels some level of entitlement to Ukraine. It may also lend a hand in an understanding that Russia always gets what Russia wants. Russia has been powerful on their own and even more powerful as part of the USSR. It is clear that Russia’s sentiment follows that Ukraine is theirs having been their leader for centuries.

Russia, led by dictator Vladimir Putin is hell bent on Ukraine not joining NATO (North Atlantic Treaty Organisation) and many believe that Ukraine’s persistence to do so was the reason for Russia’s invasion. Putin however has cited that Russia could not ‘feel safe, develop and exist’ due to what he has claimed as constant threats from Ukraine. NATO is in simple terms a Military Alliance formed by Eastern countries to protect themselves through political and military means. For many years Ukraine has tried to become a member of NATO but they have not been able to meet the requirements in terms of policies’ readiness and other factors.

Despite Putin’s disagreement that a war has started, the truth is, a war is underway between Russia and Ukraine. To put things into context, it is important to understand who these countries are and how the World can be impacted by this war. Russia’s GDP stands at USD1.48Tn while Ukraine’s GDP at USD155Bn. Simply put, Russia is the 11th largest country in the world with the United States at number 1 with GDP of USD20.94Tn.

Russia currently supplies 40% of the EU’s natural gas imports and 25% of the EU’s oil supply (BBC). This means that these European economies will be faced with the inflationary impact of rising energy prices if the war persists and Russia decides to cut supply to these neighbouring countries. Russia provides the US with 8% of their oil supply. Currently (March 8th 2022) the price of WTI crude is USD123.70bbl after ending 2021 at USD88/bbl. On a similar path, the price of natural gas has risen to USD4.527/mmbtu from 2021 year’s end at USD3.76. Putin has cited that oil will likely reach US300 per barrel if he cuts supply to the EU region.

In an effort to try to derail Putin’s actions, several countries have stepped in including the US, EU, UK, Turkey, Switzerland, Canada and Japan, applying sanctions on Russia’s imports, cutting air transportation and more. The United States in particular have thus far cut Russia off from their Swift system, banned all oil imports from Russia, placed sanctions on eight Russian oligarchs, cut Russian activity through Visa and MasterCard platforms, ceased all transactions with the Russian Central Bank to name a few.

The valiant EU has also put in place sanctions similar to the US, however they must tread lightly given their economies are heavily dependent on Russian oil and gas which cannot be easily replaced by another source in the short term. The EU is the world’s largest exporter of manufactured goods and services and is itself the largest export market for over 80 countries, with their largest export market being China at 16.1% followed by the United States at 15.2%. Only 4.8% of their exports are to Russia therefore if any embargoes are placed on Russian’s imports the EU will not be seriously harmed. With significant exports going to the US, it is likely that the US will encounter higher import costs and dampen consumer spending while exacerbating supply challenges.. Approximately 18% of US imports are from the EU.

Although Russia is benefiting from higher energy prices, isolation from financial markets and freezing of internationally held reserves has led to a free falling currency and 20% interest rate environment. The country is facing severe economic challenges. Sanctions are likely to keep investors out.

For investors in the US equity market, the major concern should be inflation due to rising energy prices and the impact on consumer spending. Even if the US bans Russian oil and gas imports, the price of the commodities will continue to rise as global energy supply becomes an issue with the ongoing war. The US also will face some inflation from the higher costs expected from EU and other importing countries. Rising energy prices will likely filter into a smaller consumer budget for discretionary spending hence altering the economies’ near term growth outlook. While the US has only now begun to recover from the effects of the pandemic, inflation has been on a constant rise due to supply chain issues. The Fed is therefore still on its path to raising interest rates at the March meeting, however it is likely that the pace and timing of further hikes will have to be reconsidered as the Central bank will be careful not to raise rates at a pace to curb economic activity any further.

Investors should pay attention to the companies they have exposure to Russia/Ukraine and those that uses commodities from the EU. Companies whose imports are from the EU and other countries facing higher energy prices will likely pass on higher costs to consumers acting effectively as an inflation hedge. Again the risk remains that the EU may be cut from Russian energy supply impacting on the EU’s production and exports and further adding to supply chain issues.

We have seen the US markets pull back over 12% since its highs of January 2022. This correction can be compared to 26 historical corrections, which have averaged 13.70% each time since WWII. Recovery would have taken 4 months on average notwithstanding any bear market entry. In the past, the market has entered the bear territory 12 times since WWII (that is if the market falls 20% from its most recent high) Actual bear market declines averaged 30% over a 14 month period with recovery taking approximately 24 months. As fear has risen due to the conflict (you can see this in the VIX), the chart below have shown that during times of geopolitical conflict externally from the US, it is a good time to add to your positions or buy if you are thinking about investing for the long term.