How a Russian-Ukraine conflict might hit global markets

Investors on Friday got a taste of the sort of market shock that could come if Russia invades Ukraine.  The spark came after the White House warned Americans should leave Ukraine immediately due to worries about an imminent invasion by Russia.  US equities extended a selloff to end sharply lower, crude prices surged to a seven-year high to close in on the psychological important $100 a barrel level, while a round of buying interest in traditional safe-have assets pulled down Treasury yields and lifted gold and the US dollar.

Investors had till now been counting on a diplomatic resolution of the matter, but recent developments indicate this may be wishful thinking and therefore, not fully priced into the markets.  To be clear, the Russian stock market, which normally trades in synch with oil prices, has already lost more than a quarter of its value since the start of the Russian military buildup on the borders of Ukraine in October.  However, Russia’s representation in global indices is relatively small, making up for only 3.2% of the MSCI Emerging Markets Index and a mere 0.4% of the global stock market, measured by the MSCI World Index.

With the prospect for energy disruptions and punitive sanctions, German and Eastern European countries, Russia-focused banks and companies with significant sales in the country look the most exposed.  Russia is Europe’s main energy supplier, providing around 35% of the bloc’s natural gas requirements and thus any disruption to gas deliveries would be of a particular issue for German manufacturers – such as Siemens AG - making the DAX more vulnerable than other country indices.  Given the high stakes involved, and as part of possible sanctions, Germany has said it could halt the new Nord Stream 2 gas pipeline from Russia in case of an invasion inside Ukraine’s borders.  The pipeline is projected to increase gas imports to Europe but also underlines the bloc’s energy dependence on Moscow.

In the financial sector, the risk is primarily concentrated in Europe.  Austria’s Raiffeisen Bank International AG became the first large European lender over the past few weeks to say that it is setting aside money to deal with potential fallout from the crisis.  The bank derives almost a fifth of its revenue and around 40% of its profits from its Russian subsidiary.  Other banks with a meaningful footprint in Russia include Italian bank UniCredit and France’s Societe Generale, with both generating mid-single digit percentages of their profits in the region.

Despite the widespread risk, however, some companies could be better positioned in the case of an escalation in tensions.  European oil and gas companies would be expected to benefit on balance, as any blows to revenues or profits would be somewhat offset by a potential oil price jump.  Among European names particularly exposed to Russia are BP which owns a 19.75% stake in Rosneft, and Shell which holds a 27.5% stake in Russia’s first LNG plant, Sakhalin 2.  US energy firm Exxon Mobil operates through a subsidiary the Sakhalin 1 oil and gas project, while Norway’s Equinor is also active in the country.

In terms of the impact on the broader equity markets, history shows that as long as military conflicts remain relatively localized, the impact is generally not expected to be felt for too long, with only little measurable effect for diversified investors.

By contrast, a major risk event usually sees investors rushing back to bonds, particularly sovereign issuers of the highest quality, as they are generally seen as the safest assets, and this time may not be different, even if a Russian invasion of Ukraine risks further fanning oil prices – and therefore inflation.  In fact, if Ukraine is attacked, the Fed may have to reconsider its recent hawkish twist as the war would make the outlook even more uncertain.  However, the counter argument would be that a jump in energy prices would underline the Fed’s worries over inflation.

This crisis comes at a time when investors were already dealing with a spike in inflation and a hawkish turn by major central banks globally which had a major impact on risk markets since the start of the year.  With the escalation of tensions on Ukraine’s borders, investors will have to brace for further volatility as the market will potentially have to test new bottoms before it may bounce back with the risk of a premature slowdown in global growth.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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