Is the dam finally breaking? Over the past couple of days, Russia disavowed Ukrainian sovereignty, formally recognised the country’s breakaway provinces—Luhansk and Donetsk—as independent states and sent troops into them. In response, the UK, US and EU announced some sanctions and Germany officially abandoned its pursuit of the Nord Stream 2 pipeline. Oil prices jumped closer to $100 a barrel, and whilst European stock markets were overall mixed, global stocks fell -0.8%.[i] In doing so, world stocks notched the first official correction of this bull market—the first drop below -10% from the prior closing high.[ii] With that in mind, if you are investing in stocks for long-term growth, we think it is most beneficial to stay cool. In our view, stocks are behaving as they normally do amidst escalating geopolitical tensions. Our research finds regional conflict can hit sentiment and cause short-term declines, as it has this year. But there is a long history of regional conflicts and corresponding stock returns, and none have been the proximate cause of a bear market (a lasting broad market decline of -20% or worse with a fundamental cause). We don’t think this time is likely to prove different.
Not that any of the present situation is good—it isn’t. War is tragic. Our hearts go out to the many Ukrainian people whose lives and property are at risk, and we hope conflict doesn’t escalate from here. Yet we find markets are cold-hearted and rational, so when assessing conflict’s impact on stocks, we think it is vital to be more detached and assess the facts. One tough fact most Western commentators we follow seem to broadly overlook: Russian presence in Luhansk and Donetsk isn’t new. Russian soldiers reportedly entered these areas back in 2014, in unmarked combat fatigues, earning the moniker of President Vladimir Putin’s little green men.[iii] As many in the region reported at the time, they were offering support to forces described as pro-Russian separatists in these provinces as Russia executed its annexation of Crimea. As with Crimea, Putin argued these areas were much more ethnically Russian than Western Ukraine, seemingly attempting to justify his actions on cultural grounds.[iv] Many observers we follow in the US and Europe expressed surprise when Putin didn’t annex Donetsk and Luhansk as well as Crimea, instead appearing to settle for fomenting chaos and severing them from Kyiv’s oversight. His diplomatic recognition of Luhansk and Donetsk this time is noteworthy, but we think it—and the official statement Russian troops are headed into these regions—is tantamount to Russia formally admitting to its stance from the last eight years.
In our view, the events of eight years ago highlight a critical point for stocks: Our research shows markets move most on surprises, and nothing happening in Ukraine today appears all that new or surprising. Considering stocks reflect all widely known information, we think it stands to reason they have known and dealt with the possibility of Putin carving up the country for many years now. Once official Russian troops amassed along the border, many geopolitical commentators we follow started portraying formal activity in Eastern Ukraine as a foregone conclusion. The chief question to us was how much the West would stomach before applying economic pressure, and we are now getting some clarity on that.
Where this goes precisely is unknowable. Maybe Russian troops will advance on Kyiv, maybe not. Some geopolitical analysts we follow argue Putin’s goal is to win a firm commitment to keep Ukraine out of NATO and the EU—perhaps that is true, and maybe that is the outcome. Yet we have also seen speculation that he wants more control of the supply chains for strategic gases and minerals that run through Ukraine, in order to have more leverage over Western militaries and the Tech industry. Some analysts say any fighting would likely stay in Ukraine. Others warn it would quickly ripple through Moldova to Eastern Europe. Some think tough Western sanctions won’t invite retaliation, as Russia’s government financing depends on selling oil and gas to Europe.[v] Others disagree. In short, there are myriad possibilities, and we think the widespread discussion is helping markets deal with them. The more chatter there is now, the less surprise power there likely is if and when something worse occurs.
Yet our research shows markets also move most on probabilities, not possibilities. Our study of global market history finds regional conflicts routinely drive localised economic problems in the areas around the fighting, and we think stocks are pricing that in accordingly. The MSCI Russia’s double-digit drop today is evidence of that, in our view.[vi] But unless conflict goes global, we find the damage tends to be too small and localised to cause bear markets. Of all the conflicts since good S&P 500 data begin in 1925, only the advent of World War II caused a bear market. In 1938, we think stocks were recovering from the 1937 bear market, which our research finds erupted from misguided and harmful US Federal Reserve policy.[vii] But when Nazi Germany annexed the Sudetenland (then part of Czechoslovakia), we think it forced markets to reckon with Hitler’s territorial ambitions and the mounting likelihood of war engulfing Continental Europe. Thus began a renewed bear market, which lasted until 1942.[viii]
Using S&P 500 returns in USD for their long history and large share of global markets, none of the many conflicts that marred the ensuing decades caused a bear market. Not the Korean War. Not the Cuban Missile Crisis. Not the Six Day War. Not the Iran/Iraq War. Not the first or second US-led wars in Iraq. Not the Balkan War. Not Israel’s conflict with Hezbollah. Not the Syrian Civil War. Not Western involvement in Libya or Afghanistan. And not Russia’s 2014 invasion and annexation of Crimea. In most of these instances, stocks tumbled as tensions escalated, but they began bouncing back as or shortly after fighting broke out.[ix] We think this was the case not because armed combat is bullish, but because the fighting ended the uncertainty. When markets get clarity, even if what they see isn’t great, we think it lets them weigh the extent of the damage and move on. We don’t think this time is likely to prove different. Whilst this might sound cold to say, Ukraine’s investible market contains just two companies, and its gross domestic product (GDP, a government-produced measure of economic output) is just 0.2% of the world’s total.[x] War ravaging the nation would be awful, but given the global economy’s size, mathematically, it would take trillions of pounds’ worth of damage to cause a global recession (broad decline in economic activity). In our view, Ukraine just isn’t big enough—nor are the surrounding former Soviet states that aren’t in NATO and therefore stand the highest likelihood of being drawn in.
It won’t shock us if the announcement of sanctions, possibility of escalating conflict and potential Russian economic retaliation draws out the volatility for a while longer. Brace yourself for that now—fearful headlines can trigger short-term reactions. But eventually that tends to wear off and markets resume weighing fundamentals, coldly and rationally. As they do, we think they will see that the probability this spirals into a recession-inducing global conflict is exceedingly low. On the oil and gas front, we have already seen producers outside the Organisation of Petroleum Exporting Countries cartel help mobilise a supply response, which should help take some of the sting out.[xi] Higher prices will likely bring even more production back online in the US, Canada and elsewhere. In commodity markets, when one supplier leaves a market, others generally take its place. We think that should keep Europe’s lights on, and spring’s approach should offer additional relief.
We will continue watching things closely and will share updates and analysis as warranted. For now, take a deep breath, steel your nerves, and remember how markets work.
[i] Source: FactSet, as of 22/2/2022. MSCI World Index return with net dividends on 22/2/2022.
[ii] Source: FactSet, as of 22/2/2022. Statement based on daily price movement of Brent crude oil prices, Stoxx Europe 600, CAC 40, DAX, FTSE MIB, IBEX, AEX and MSCI UK indexes in local currencies on 22/2/2022. Currency fluctuations between the pound and euro may result in higher or lower investment returns. MSCI World Index returns with net dividends, 8/12/2021 – 22/2/2022. A bull market is an extended period of overall rising stocks.
[iii] “Everything You Need to Know About the 2014 Ukraine Crisis,” Max Fisher, Vox, 3/9/2014.
[v] Source: US Energy Information Administration, as of 22/2/2022.
[vi] Source: FactSet, as of 22/2/2022. Statement based on MSCI Russia price return in roubles on 22/2/2022. Currency fluctuations between the pound and rouble may result in higher or lower investment returns.
[vii] Ibid. Statement based on S&P 500 price returns in USD. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
[x] Source: FactSet and World Bank, as of 22/2/2022.
[xi] “US Finalizes Plan to Divert Gas to Europe If Russia Cuts Off Supply,” Julian Borger, The Guardian, 25/1/2022.
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