Stand with Ukraine

 

There is little doubt that we have all been preoccupied for the past few weeks by Putin’s shocking decision to invade Ukraine. While we are horrified by the humanitarian crisis unfolding before our eyes, and the situation is changing quickly, our job is to remain focused on how it could impact our client’s hard-earned savings over the long term so we will try to focus our comments on the financial implications of this event.

Here’s our understanding of where things stand and where they could go from here:

• Russian troops crossed into Ukraine on Feb 24^th, and show little signs of letting up 10 days later despite halting progress, considerable opposition from Ukrainian nationals, and crippling financial sanctions from the West on Russia and its oligarchs. If we view the annexation of Crimea in 2014 and the continued violence in Donbas as part of the same “operation,” we have to assume that Putin will press forward until his goals are reached.
   
• 200,000 troops is a small force to occupy a hostile nation with a population of 41MM. France in 1939 had a similar population to Ukraine today, and the Nazi’s invaded with a force of 3.5MM infantry, 5,500 aircraft and 10 Panzer divisions, and still faced considerable resistance in the years ahead. While we are all hoping for a diplomatic solution, we have to prepare that this conflict could last much longer than we currently expect it to. If it does, the civilian tolls will rise, the refugee numbers will increase, and the economic fallout will persist.
   
• To date, Russia has born the brunt of this fallout. The sanctions have and will take a heavy toll on Russia’s economy. Russian bonds are trading for $0.225 on the dollar, reflecting a high risk of default. Greater than 70% of the Central Bank of Russia’s $630B in foreign reserves have been frozen by the western banks in which they’re held, forcing the bank to raise its benchmark rate to 20% to defend the ruble, which has lost 60% of its value in a matter of weeks. The Russian stock market has been halted for 2 weeks, and major index fund providers like MSCI have declared Russia’s stocks to be “uninvestable.” And the sanctions have just started – western nations are openly talking about freezing Russia out of international oil markets, which would eliminate a key source of revenue for this nation (comprising 63% of Russia’s total exports).
   
• Wars are expensive. The Iraq War cost the U.S. more than $3 Trillion.  Current estimates are that the war in Ukraine cost Russia US$7B in its first 100 hours alone.  When the sanctions were put in place, the estimated cost skyrocketed to about $20B / day, which would be the equivalent of Russia’s entire annual GDP if it lasted more than 85 days. Several oligarchs suspected of bankrolling Putin have seen their assets frozen, yachts seized, and are already starting to break ranks publicly with Putin by criticizing the war in the Ukraine. Queues are forming at Russia’s ATMs and grocery stores, and 4,300 have already been arrested in protests in Russia despite threats of 15-year jail sentences. Putin has to be feeling pressure to complete the mission or to seek a diplomatic solution, and fast.
  (Source: https://www.consultancy.eu/news/7433/research-ukraine-war-costs-russian-military-20-billion-per-day)
   
• Russia’s GDP in 2021 was $1.7 trillion. While that sounds like a lot, that’s only 1.8% of global GDP, about the same size as Canada. And Russia is heavily dependent on Europe, with 37% of its exports destined for Europe. This is a one-sided relationship, with only 4.8% of Europe’s exports destined for Russia. However, Russia produces 26% of the oil and 40% of the natural gas consumed by Europe, and Russia and Ukraine combine for ~30% of the world’s total wheat production and ~15-20% of global corn production. With inflation hitting 20 years highs, and gasoline prices hitting highs last seen in 2008, it is clear that the biggest risk to the global economy posed by Russia is an inflation shock hitting the pocketbook of the global consumer. 
   
• To date, the broad market is not expecting that to transpire. The fallout has been relatively contained, but volatility has been high. The MSCI World, a benchmark of global stock prices, has fallen only 1.13% (in CAD$) since combat began on Feb 24 through to market’s close on Mar 4, 2022. European stocks have been hardest hit, falling 6.75%. Bonds have been relatively stable, though the “spread” demanded for the risk of default on investment grade (IG) and high yield (HY) bonds has modestly increased (by 15bps to 4.04% for HY Bonds, and by 6bps to 1.63% of IG bonds). The yield curve has flattened, but is still not signaling that a recession is forthcoming.
   
• While unwelcome, events like this have historically not had a lasting market impact, with very few exceptions. U.S. stocks, on average, have marched higher in the years that follow, as you can see from the table below.
   
• We anticipate that the longest lasting impact of this event will be increased spending on defense and energy independence by Europe and the U.S. But it is early days, and the range of potential outcomes is wide. For example, while a low probability event, there is heightened risk is that China uses this distraction to seize control of Taiwan, which would have a more outsized impact on the global economy.
   

At face value, the decision to invade Ukraine has been an unmitigated disaster for Vladimir Putin, and one that hopefully signals his departure from a prominent role in international politics. His stated goal was to ensure Ukraine did not join NATO and to fight extremism in the Eastern provinces bordering Russia. However, it is clear that his main motive was to reunite parts of the Russian sphere of influence lost during the dissolution of the Soviet Union. His moves have instead galvanized NATO, wreaked havoc on his nation’s economy, undermined the oligarchs’ support for him, and induced the re-armament of Germany, which has committed to spending 2% of GDP to modernize its military for the first time since WWII. Still, Putin is dangerous. Nuclear and cyber security threats are still at his disposal. A diplomatic off-ramp will have to be carefully orchestrated. Like you, we hope that diplomacy will be the route taken in the days and weeks ahead.

 

 

 

 

 

 

 

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