Looking beyond the geopolitics

Equity markets have been volatile in recent weeks as investor sentiment dampened, oscillating between hopes for a diplomatic resolution to the Russia-Ukraine situation and fears of an armed conflict. At the point of writing, tensions have escalated with Putin declaring commencement of military operations in Ukraine on February 24^th. 

A number of conflicting dynamics come into play when assessing the impact of Russia’s recent actions in Ukraine:

• Complete annexation of Ukraine proves quite challenging, given its population of 44 million, and considering 90% of Ukrainians had voted to leave the Soviet Union in 1991.
• The extent and effectiveness of the sanctions imposed by the US, UK and the EU. On February 22^nd, the US, UK and the EU implemented a first wave of sanctions, which included restricting the sale of Russian sovereign debt, and freezing the assets of Russian oligarchs and their children, banks and parliamentarians. Germany also paused the certification of Nord Stream 2, an undersea pipeline intended to carry more gas from Russia to Germany. 
• The potential retaliation from Russia, a major nuclear power and global supplier of critical materials. Russia is the world’s largest exporter of fertiliser and accounts for 43% of the world production of palladium, which is used in catalytic converters in cars. There is also increased risk of cyber-attacks, which have already started in Ukraine.
• Europe’s dependence on Russian energy imports, in particular gas. Russia accounts for about one third of the gas burned in Europe and slightly more than 50% of Germany’s gas imports.
• The ability of Russia to better defend itself against potential sanctions given the current high oil price, low debt levels (government debt to GDP estimated to be 17.9% as at 2022¹) and high level of foreign exchange reserves (~USD 630 bn).
• Russia’s role as an energy provider to the world and the implications of the Russia-Ukraine tensions on already high oil prices, which have surged to seven-year highs.

Encouragingly, lessons from history suggest that the impact of geopolitical events on equity markets tend to be short-lived. The closest example we can refer to may be the Russian annexation of Crimea in February 2014. While oil prices peaked around the event, there was no lasting impact on asset prices. The S&P 500 experienced volatility in the three weeks leading into the incursion, but the recovery was relatively swift. The impact on Asian equities was relatively muted. Higher oil prices arising from 2014’s sanctions provided a tailwind for Europe’s oil and gas sector, lending a boost to the European equity market. Fig. 1.

Fig. 1. Selected market performances pre and post annexation of Crimea

Broadening our analysis to include geopolitical events from 2010 to 2020, we note that the average maximum declines² for the S&P 500 and MSCI Asia ex Japan indices arising from geopolitical events were 9.0% and 12.3%, respectively. Fig. 2. Interestingly, the maximum declines for the S&P 500 and MSCI Asia ex Japan Indices appear to be the largest for geopolitical events that take place in the Middle East. While markets may experience more volatility as the uncertainty persists, we note that any de-escalation of tensions could potentially result in a sharp snapback in equity markets.

Fig. 2. Maximum declines according to location of geopolitical events

Importantly, 12 months following the cited geopolitical events, the average returns for the S&P 500 and MSCI Asia ex Japan indices have been positive at 11.9% and 7.1% respectively. History shows that geopolitics have been largely responsible for market pullbacks, but not bear markets. See Fig. 3.

Fig. 3. Geopolitical events and impact on US and Asian equity markets

While geopolitical risks are currently very much in focus, inflation is likely to be the more enduring theme for markets going forward and have a longer lasting impact on portfolio returns. Most investors have since accepted that inflationary pressures are here to stay. In the US, the Consumer Price Index (CPI) is likely to remain on an uptrend in 2022 while continued supply bottlenecks will feed into the core Personal Consumption Expenditures (PCE) Price Index.