As the world’s attention is focused on
the war in the Ukraine, it is the human toll, in death and injury, that
should get our immediate attention, and you may find a focus on
economics and markets to be callous. However, I am not a political
expert, with solutions to offer that will bring the violence to an end,
and I don’t think that you have come here to read about my views on
humanity. Consequently, I will concentrate this post on how this crisis
is playing out in markets, and the effects it has had, so far, on
businesses and investments, and whether these effects are likely to be
transient or permanent.
The Lead In
To understand the
market effects of the Russia-Ukraine conflict, we need to start with an
assessment of the two countries, and their places in the global
political, economic and market landscape, leading in. Russia was
undoubtedly a military superpower, with its vast arsenal of nuclear
weapons and army, but economically, it has never punched that weight.
Ukraine, a part of the Soviet Union, has had its shares of ups and
downs, and its economic footprint is even smaller. The pie chart below,
provides a measure of the gross domestic product of Russia and Ukraine,
relative to the rest of the world:

While
Russia’s share of the global economy is small, it does have a
significant standing in the natural resource space, as a leading
producer and exporter of oil/gas, coal and nickel, among other
commodities. Ukraine is also primarily a natural resource producer,
especially iron ore, albeit on a smaller scale.

Russia
was also a leading exporter of these commodities, with a
disproportionately large share of its oil and gas production going to
Europe; in 2021, Russian gas accounted to 45% of EU gas imports.
The Market Reaction
As the rhetoric of war has heated up in the last few months, markets were wary about the possibility of war, but as Russian
troops have advanced into the Ukraine, that wariness has turned to sell
off across markets. In this section, I will begin by looking at the
bond market effects and then move on to equities and other asset
classes, starting by looking at the localized reaction (for Ukranian and
Russian securities) and then the global ripple effects.
Bond Markets and Default Risk
In
times of trouble, the first to panic are often lenders to the entities
involved, and in today’s markets, the extent of the reaction to
country-level troubles can be captured in real time in the sovereign CDS
(Credit Default Swap) markets. The graph below shows the sovereign
spreads for Russia and Ukraine in the weeks leading up and including the
conflict:
sovereign CDS spread for Russia, which started the year at 1.70% soared
above 25%, just after hostilities commenced, and were trading at 10.56%
on March 16, after rumors that peace talks were underway brought them
down. The sovereign CDS spread for the Ukraine started the year at 6.17%
and climbed in the first few days of the crisis to more than 100%
(effectively uninsurable) before settling in on March 16 at 28.62%. Even
the ratings agencies, normally slow to act, have been moving promptly,
with Moody’s lowering Russia’s rating from Ba2 to B3 on March 3, from B3
to Ca on March 6 and from Ca to C on March 8, and Ukraine’s rating from
B3 to Caa2 on March 4. Other ratings agencies have also taken similar
actions.
about default have not stayed isolated to Russia and Ukraine, as ripple
effects have shown up first in the countries that are geographically
closest to the conflict (Eastern Europe) and more generally on sovereign
CDS spreads in the rest of the world. The graph below looks at average
spreads, by region, before and after the hostilities started:
![]() |
Change in Sovereign CDS, by Region |
There
are no surprises in this table, with the effects on spreads being
greatest for East European countries. Note, though, that while sovereign
CDS spreads increased almost 51% between January 1, 2022 and March 16,
2022, in these countries, the overall riskiness of the region remains
low, the average spread at 1.30%. The Middle East is the only region
that saw a decrease in sovereign CDS spreads, as oil, the primary
mechanism for monetization in this region, saw its price surge during
the last few weeks. The Canadian sovereign CDS spread widened, but US
and EU country spreads remained relatively stable.
The increase in default spreads was not restricted to foreign
markets, as fear also pushed up spreads in the corporate bond market. In
the table below, I look at default spreads on bonds in different
ratings, across US companies, on January 1, 2022 and March 16, 2022:

is worth noting that corporate bond spreads, which were are at historic
lows to start the year, were already starting to widen before Russia’s
military moved into the Ukraine on February 24, 2022, but the invasion
has pushed the spreads further up at the lower ends of the default
spectrum. The overriding message in all of this data is that
Russia/Ukraine war has unleashed fears in the bond market, and once
unleashed that fear has pushed up worries about default and default risk
premia across the board.
Lenders
may be the first to worry, when there is a crisis that puts their
payments at risk, but equity investors are often with them, pushing down
stock prices and pushing up equity risk premiums. Again, I will start
with Russian and Ukranian equities, using country indices to capture the
aggregate effect on these markets, from the invasion:
![]() |
Russia: RTX Russian Traded $ Index, Ukraine: Ukraine PFTS Index |
index is particularly representative, and currency effects contaminate
both, but they tell the story of devastation in the two markets. In
fact, since trading has been suspended on both indices, the extent of
the damage is probably understated. To get a better sense of how Russian
equities, in particular, have fared in the aftermath of the invasion, I
looked at four higher profile Russian companies,:

is Russia’s largest technology company. In addition to being traded on
the MICEX, the Russian exchange, these companies all have listings in
foreign markets (Yandex has a US listing and the other three are listed
on the London Exchange). The collapse in stock prices has been
calamitous, with each of the four stocks losing almost all of their
value, and with trading suspended since the end of February, it is still
unclear whether the trading will open up, and if so at what price.

A
knee-jerk contrarian strategy may indicate that you should be buying
all these stocks, as soon as they open for trading, but a note of
caution is needed. The price drop in these companies, especially severe
at Sberbank, is not necessarily an indication that these companies will
cease to exist, but that the Russian government may effectively
nationalize them, leaving equity worthless.
As Russian equities have imploded, the ripple effects again are being
felt across the globe. The table below summarizes the market cap
change, by region of the world:

It
is no surprise that Eastern Europe and Russia, which are in the eye of
the hurricane, have seen the most damage to equities, but other than the
Middle East, every other equity market in the world is down, with the
US, EU and China shedding significant market capitalization. Slicing the
data based on sector yields the following:

Against,
there are no surprises, with energy being the only sector to post
positive returns and with consumer discretionary and technology
generating the most negative returns. Finally, I looked at firms based
upon price to book ratios as of January 1, 2022, as a rough proxy for
growth/maturity, and at net debt to EBITDA multiples, as a measure of
indebtedness:

this crisis, the conventional wisdom has held, at least so far, with
mature companies holding their values better than growth companies.
Since these mature companies tend to carry more debt, you see more
indebted companies doing much better than less indebted companies. While
the value crowd, bereft of victories for a long time, may be inclined
to do a victory dance, it is worth noting that the same phenomenon
occurred between February and March of 2020, at the start of the COVID
crisis, but that growth companies quickly recouped their losses and
finished ahead of mature companies by the end of 2020.
In keeping with my belief that it is the price of risk that is
changing during a crisis, causing contortions in prices, I estimated the
implied equity risk premium for the S&P 500, by day, starting on
January 1, 2022, going through March 16, 2022, in the graph below:
![]() |
Download ERP, by day |
that equities were already under pressure in the weeks before the
invasion, as inflation fears surfaced again, and then hostilities have
put further pressure on them. The implied equity risk premium, which
started the year at 4.24%, was at 4.73% by March 16, and the expected
return on equity, which was close to an all-time low at 5.75% at the
start of the year, was now up to 6.92%, still lower than historical
norms, but closer to the numbers that we have seen in the last decade.
Flight to Safety and Collectibles
As in any crisis, there was a rush to safety, accentuated by wealthy
Russians trying to move their wealth to safe havens, with safety defined
not just in terms of currency, but also in terms of being beyond the
reach of US and European regulators and legislators. In the graph below,
I start with two traditional havens for US investors, the US dollar and
treasury bonds:
Trade-weighted dollar & US 10-year T.Bond Rate |
dollar has strengthened since February 23, with the trade weighted
dollar rising about 3% in value, but the ten-year treasury bond, after
an initial rise in prices (and drop in yields) has reversed course,
perhaps as inflation concerns overwhelm safe haven benefits. I also
looked at crisis investments, starting with gold, an asset that has held
this status for centuries and contrasting it with bitcoin, millennial
gold:
which started the year at just above $1,800 an ounce, rose from $1,850
on February 23 to peak at $2,050/oz a few days ago, before dropping back
below $2,000/oz on March 16. Bitcoin, which started the year at about
$46,000, had a strong first half of November, also rose at the start of
this crisis, but seems to have given back almost all of its gains. To
the extent that crypto holdings may be more difficulties for authorities
to trace and lay claim on, it will be interesting to see if you see a
rise in the prices of crypto currencies as Russian wealth looks for
sanctuary.
Economic Consequences
It
is difficult to argue that people were taken by surprise by the events
unfolding in the Ukraine, since the lead in has been long and well
documented. It can be traced back to 2014, when Russia annexed Crimea,
setting in motion a period of uncertainty and sanctions, and the global
economy and Russia seemed to have weathered those challenges well. As
this crisis plays out in financial markets, roiling the price of risk in
both bond and equity markets, the other question that has to be asked
is about the long term economic consequences of the crisis for the
global economy.
Commodity Prices and Inflation Expectations
Given Russia’s standing as a lead player in commodity markets, and
its role in supplying oil and gas to Europe specifically, it should come
as no surprise that the markets for the commodities that Russia
produces in abundance has been the most impacted, at least in the short
term:
four commodities saw their prices soar in the aftermath of February 23,
with oil rising to $130 a barrel, before falling back below $100, and
trading in the nickel market suspended on March 7, after prices rose
about $100,000 a ton. Even as prices rose in the spot market, the
futures market indicated that many participants believed that the price
rise would be temporary, with futures prices closer to $80 a barrel, for
a year ahead and two year ahead futures contracts.
In
a market already concerned about expected inflation, the rise in
commodity prices operated as fuel on fire, and pushed expectations
higher. In the graph below, I list out two measures of expected
inflation, one from a inflation expectations ETF (ProShares Inflation Expectation ETF) and the other from the Federal Reserve 5-year forward inflation measure, computed as the difference between treasury and TIPs rates.
Both
measures indicate heightened concerns about future inflation, and these
are undoubtedly also behind the increase in the US ten-year treasury
bond rate from 1.51% to 2.19%, this year.
Consumer Confidence and Economic Growth
The question that hangs over not just markets but economic policy
makers is how this crisis will affect global economic growth and
prospects. It is too early to pass final judgment, but the early
indications are that it has dented consumer confidence, as the latest
reading from the University of Michigan consumer survey indicates:
University of Michigan Consumer Sentiment |
Consumer
sentiment is now more negative than it was at any time during the COVID
crisis in 2020, and if consumers pull back on purchases, especially of
discretionary and durable goods, it will have a negative effect on the
economy. While the contemporaneous numbers on the US economy on
unemployment and production still look robust, worries about recession
are rising, at least relative to where they were before the hostilities.
The graph below looks at the median forecasts of recession
probabilities for the US, on the left, and for the Eurozone, on the
right (from Bloomberg):
Median forecast probability of recession, US (left) and Eurozone (right) |
As
a result of the events of the last three weeks, forecasters have
increased the probabilities of recessions from 15% to 20% for the US and
from 17.5% to 25% for the Eurozone.
Investment Implications: Asset Classes, Geographies and Companies
The
Russian invasion of Ukraine has undoubtedly increased uncertainty,
affected prices for financial assets and commodities and exacerbated
issues that were already roiling markets prior to the invasion. For
investors trying to recapture their footing in the aftermath, there are
multiple questions that need answers. The first is whether a radical
shift in asset allocation is needed, given how these perturbations,
across asset classes, geographies and sectors. The second is how the
disparate market sell off, small in some segments and large in others,
over the last few months has altered the investment potential in
individual companies in these segments. On January 1, 2022, I valued the S&P 500,
building in the expectation that the economy would stay strong for the
year and that interest rates would rise over the course of time from the
then prevailing value (1.51%) to 2.50% over five years, and arrived at a value of 4,320 for the index,
about 10.3% lower than the traded value of 4766. While that was only
ten weeks ago, the index has since shed 7.03% of its value, the T.Bond
rate has risen to 2.19% and Russia’s invasion of the Ukraine have
increased commodity prices and the likelihood of a recession. I
revisited my valuation of the index, with the updated values:
![]() |
Spreadsheet to value the S&P 500 |
are two things to note in this valuation. The first is that I have
raised the target rate for the US T.Bond to 3%, reflecting both the
increase that has already occurred this year, and concerns about how
current events may be adding to expected inflation. The second is that I
continue to use analyst estimates of earnings, and at least as of this
week (with estimates from March 14, 2022), analysts do not seem to be
lowering earnings to reflect recession concerns. That may either reflect
their belief that this storm will pass without affecting the US economy
significantly or a delay in incorporating real world concerns. If you open the spreadsheet,
I offer you the option of adjusting expected earnings, if you believe
analysts are being unrealistic in their forecasts. The net effect of the
changes is that my estimated value of the index is now 4197, making the index over valued by 5.6% as of March 16, 2022.
generally, the question that investors face as they decide whether to
reallocate their portfolios is whether the market has over or under
reacted to events on the ground.
- If
you are a knee-jerk contrarian, your default belief is that markets
over react, and you would be buying into the most damaged asset classes,
which would include US, European and Chinese stocks (worst performing
geographies), and especially those in technology and consumer
discretionary spaces (worst performing sectors), and selling those
investments (energy companies and commodities like oil, that have
benefited the most from the turmoil. - If, on the other hand, you
believe that investors are not fully incorporating the effects of the
long term damage from this war, you would reverse the contrarian
strategy, and buy the geographies and sectors that have benefited
already and sell those that have been hurt.
As an avowed
non-market-timer, I think that both these strategies represent bludgeons
in a market that needs scalpels. Rather than make broad sector or
geographic bets, I would suggest making more focused bets on individual
companies. In picking these companies, market corrections, painful
though they have been, have opened up possibilities, for investors,
though their stock picks will reflect their investment philosophies and
their views on economic growth:
- Discounted Tech: During
the course of 2022, markets have reassessed their pricing of tech
stocks, and marked down their market capitalizations, for both older,
and profitable tech and young, money-losing but high growth tech. A few
weeks ago, I posted my valuation of the FANGAM stocks and noted that
only one of them was under valued, at the prices prevailing then. In the
last few days, every company on the list has dipped in price by enough
to be at least fairly valued or even cheap. While there may be value in
some young tech companies, any investments in these firms will be joint
bets on the companies and a strong economy, and with the uncertainties
about inflation and economic growth overhanging the market, I would be
cautious. - Safety First: If you have been spooked by
market volatility and the Russian crisis, and believe that there is more
volatility coming to the market in the rest of the year, your stock
picks will reflect your fears. You are looking for companies with
pricing power (to pass through inflation) and stable revenues, and in my
view, and while you should start by looking in the conventional places
(branded consumer products and food processing, pharmaceuticals), you
should also take a look at some of the big names in technology. - The Russia Play:
For the true bargain hunters, the wipeout of market capitalization of
Russian stocks (like Sberbank, Severstal, Lukoil and Yandex) will create
temptation, but I would offer two notes of caution. The first is that
you have to decide whether you can buy them in good conscience, and that
is your judgment to make, not mine. The second is that corporate
governance at Russian companies, even in their best days, is
non-existent, and I do not know how this crisis will play out in the
long term, at these companies. After all, your ownership stake in these
companies is only as good as the legal structure backing it up, and in
Russia, that your stake may be worthless, even if these companies
recover. A less risky route would be to tag companies with significant
exposure to Russia, such as Pepsi, McDonald’s and Philip Morris, and
evaluate whether the market is overreacting to that exposure. I have
seen no evidence, so far, that this is the case, but that may change.
is one final sobering note to add to this discussion, and that relates
to low probability, potentially catastrophic events, and how markets
deal with them. There is a worst case scenario in the Russia-Ukraine
war, that few of us are willing to openly consider, where the
conflagration spreads beyond the Ukraine, and nuclear and chemical
weapons come into play. While the probability of this scenario may be
very low, it is not zero, and to be honest, there is no investing
strategy that will protect you from that scenario, but market pricing
will reflect that fear. If we escape that doomsday scenario, and come
back to something resembling normalcy, markets will bounce back, and in
hindsight, it will look like they over reacted in the first place, even
if the risk assessments were right, at the time. Put simply, assuming
that crises will always end well, and that markets will inevitably
bounce back, just because that is what you have observed in your
lifetime, can be dangerous.
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