The economic impact of the war in Ukraine

Foreword: We are aware that some of our clients may be concerned about the economic ramifications of the events taking place in Ukraine both generally and in terms of their personal portfolios. This article is intended to help those people understand and navigate the financial impacts of this event. We also wish to acknowledge and in no way diminish the horrible human toll of the war in Ukraine and similar events throughout history.

Wars have a terrible human and economic cost for the nations involved, but for the war in Ukraine, the economic shockwaves may be felt across the globe. This article seeks to explore not only the likely economic impacts of the current conflict, but also key considerations for investors during this time of heightened uncertainty.

Economic impacts

Commodity Prices and Inflation

Russia is the world’s 11th largest economy and one of its largest commodity producers. As well as being the dominant supplier of gas to Europe (see chart below), Russia is one of the world’s largest oil producers, producing 9.7 million barrels of oil per day last year, according to Rystad Energy. That is second only to the United States. Russia is also a key supplier of industrial metals such as nickel, aluminium and palladium. Both Russia and Ukraine are major wheat exporters, while Russia and Belarus (a Russian proxy) are big in potash, an input into fertilisers.

The prices of these commodities have been rising this year and are now likely to rise further.

Oil supply is already failing to keep up with demand and European gas prices have already risen by 30%. Further supply shortfalls could occur through a variety of ways, including damage to infrastructure during the war, sanctions on Russia and Putin moving to weaponise exports through the restriction of supply. According to the Economist (Feb.2022), up until now both sides have been wary about weaponising the trade in energy and commodities, however the prospect now is of more Western restrictions on Russia’s natural-resources industry that will curtail global supply. Russia may retaliate by deliberately creating bottlenecks that raise prices. According to JP Morgan, if Russian oil exports are halved, the price of crude, already trading at the highest point since 2014, could reach US$150 a barrel. Higher oil and natural gas prices would lead to higher petrol and energy prices. The inevitable flow-on effect is that inflation, already a major problem for the US economy, will likely get worse as input costs along the supply chain continue to increase. This includes heating, electricity, transportation and the raw materials themselves. The inflationary pressure would, of course, be worse for Europeans.

Borrowing Costs

If the inflation situation worsens, central banks globally will come under increased pressure to increase interest rates to combat the problem. This could mean faster rate hikes to cool off inflation and in turn increased borrowing costs for consumers. Fixed and variable mortgage rates in Australia have already come off their Covid lows without any change to the RBA cash rate. If rates increase too quickly it could lead to not only a slowing of the economy but potential financial stress for highly leveraged borrowers. At a minimum, the Russia-Ukraine situation will further complicate central banks’ already difficult task of taming inflation without sparking a recession.

Market turbulence

Markets famously detest uncertainty. In the US, the Dow-Jones index tumbled 700 points the morning after the invasion, while here in Australia we saw a 3% drop in the All-Ordinaries index. This is not surprising as investors confront the possibility of an oil shock, higher inflation and a confusing sanctions regime, which now includes blocking Russian banks from the SWIFT financial system and tough restrictions on its central bank.

Unsurprisingly, the war and subsequent sanctions have had a massive impact on Russia’s domestic market and currency. The MOEX index has fallen over 30% in the past three weeks and almost 42% since its peak in October 2021. The Russian Ruble has collapsed by nearly 30% in the span of a month causing massive short term inflation and the Russian central bank to raise interest rates to 20%. However, with a total market capitalisation of around US$365B (before the current crisis), Russia is still considered an ‘emerging market’ and represents a very small proportion of global markets. To put this in context, Australia has a market cap of US$1,861B and the world’s largest company, Apple, has a market cap of US$2,931B. It is also important to note that recent falls have been on the back of a couple of tremendous years for stock markets. From their March 2020 lows, US shares had risen 114% and Australian shares rose 68% to their most recent highs. There is likely to be more short term volatility as the geo-political crisis in Ukraine evolves and the global economic implications begin to manifest.

Note for Investors

Sharp market falls are stressful for investors as no one likes to see their investments fall in value. This is often worsened during times like this as the flow of negative news reaches fever pitch and is being accentuated through social media. However, stocks do have a history of rebounding from geopolitical scares. In fact, research by Bill Stone of Glenview Trust found that of 29 different geopolitical crises examined starting with WWII, the average time taken for markets to recover to pre-crisis levels was only 3 months. In 66% of the events, the sharemarket was higher after only one month. In addition, sometimes there can be significant jumps sharply after a crisis leading to significant opportunity cost for those who elect to get out of the market.

So, while investors should be prepared for additional volatility, history does seem to suggest that stock declines associated with geopolitical fears are generally a temporary setback and may even be an opportunity to buy at discounted prices. This is further illustrated in the chart below.

Bouts of volatility is the price we pay for higher longer-term returns from markets. That is the trade-off and it is why well-diversified portfolios with asset allocations in line with individual investor risk-profiles and tolerance to volatility is foundational to how we manage money for our clients. It is also important to note that exposure to the Russian sharemarket within the Sherrin Partners model portfolios is less than 0.5%. The best course of action is to turn down the noise, stick to your long-term investment strategy, and not try to time markets. Remember, markets tend to overcome short term corrections during times of geopolitical crisis fairly quickly and those with discipline and a long-term outlook will be rewarded.

References

Dimensional, 2022. Matrix Book 2021 – Historical Returns Data—Australian And New Zealand Dollars. 40th ed. Dimensional.

European Union Agency for the Cooperation of Energy Regulators, 2021. High Energy Prices. [online] Available at: <http://chrome-extension://efaidnbmnnnibpcajpcglclefindmkaj/viewer.html?Pdfurl=https%3A%2F%2Fextranet.acer.europa.eu%2F%2fofficial_documents%2fposition_Papers%2fposition%2520papers%2fenergy%2520Prices_Final.pdf&clen=2361157&chunk=true>

J.P.Morgan, 2022. What’s Next For Oil And Gas Prices As Russia-Ukraine Tensions Rise? | Energy Outlook | J.P. Morgan. [online] Jpmorgan.com. Available at: <https://www.jpmorgan.com/insights/research/oil-gas-energy-prices>

OEC – The Observatory of Economic Complexity. 2022. Russia (RUS) Exports, Imports, and Trade Partners | OEC. [online] Available at: <https://oec.world/en/profile/country/rus>

Oliver, S., 2022. Share market falls – seven things for investors to keep in mind | AMP Capital. [online] AMP Capital. Available at: <https://www.ampcapital.com/au/en/insights-hub/articles/2022/january/share-market-falls-seven-things-for-investors-to-keep-in-mind>

Oliver, S., 2022. The escalation in Ukraine tensions – implications for investors | AMP Capital. [online] AMP Capital. Available at: <https://www.ampcapital.com/au/en/insights-hub/articles/2022/february/the-escalation-in-ukraine-tensions-implications-for-investors>

Rystad Energy, 2022. Russia-Ukraine tensions could jeopardize 30% of European gas demand – US LNG can play a role in bridging the gap. [online] Available at: <https://www.rystadenergy.com/newsevents/news/press-releases/Russia-Ukraine-tensions-could-jeopardize-30-of-European-gas-demand-US-LNG-can-play-a-role-in-bridging-the-gap/>

Rystad Energy, 2022. OPEC brinkmanship puts spotlight on US supplies as Russia crisis escalates. [online] Available at: <https://www.rystadenergy.com/newsevents/energy-market-thoughts/2022/opec-brinkmanship-puts-spotlight-on-us-supplies-as-russia-crisis-escalates/>

Statista, 2022. Russian gas dependence in Europe by country 2020 | Statista. [online] Statista. Available at: <https://www.statista.com/statistics/1201743/russian-gas-dependence-in-europe-by-country/>

Stone, B., 2022. Should You Sell Stocks In Response To A Conflict In Ukraine?. [online] Forbes. Available at: <https://www.forbes.com/sites/bill_stone/2022/02/20/should-you-sell-stocks-in-response-to-a-conflict-in-ukraine/?Sh=7a4b870e3cd7>

Tan, W., 2022. How a Russian invasion of Ukraine, the ‘breadbasket of Europe,’ could hit supply chains. CNBC, [online] Available at: <https://www.cnbc.com/2022/02/23/impact-of-russia-ukraine-on-supply-chains-food-metals-commodities.html>

The Economist. 2022. The economic consequences of the war in Ukraine. [online] Available at: <https://www.economist.com/finance-and-economics/2022/02/26/the-economic-consequences-of-the-war-in-ukraine>

Image sources: Statista 2020, European Union Agency for the Cooperation of Energy Regulators & ASX, AMP.

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