Back in the USSR

Russian troops blockade a Ukrainian base in the Crimea. Photo by Sean Gallup/Getty Images.

The crisis in Crimea rocked global markets Monday as investors reacted to Russian aggression that Ukraine’s leadership called a “declaration of war.” The EU spent the day mulling its response while Russian troops reportedly seized border posts and threatened to take over two Ukrainian warships in the Black Sea, and investors globally wondered whether the conflict could cause markets to take a prolonged pounding. In the near term, volatility could very well continue—the threat of armed conflict drives uncertainty and often rattles investor sentiment. But the likelihood this escalates into something massive and global enough to have a lasting impact on markets appears slim.

The situation itself is terrible. Less than a week after Ukraine’s parliament ousted President Viktor Yanukovych—which followed protests where dozens of pro-Western Ukrainian demonstrators were killed by government snipers—heavily armed “unidentified” masked men began seizing government buildings and airports in the autonomous region of Crimea. Within three days, Russian soldiers fully occupied the peninsula, deposed its leadership, installed a pro-Russian administration, and blocked all Ukrainian bases. Meanwhile, in the Motherland, Parliament passed a measure authorizing Russian intervention anywhere in Ukraine and introduced another bill to streamline the process for annexing foreign territory. Russian dictator ... err, President Vladimir Putin said the moves were necessary to protect ethnic Russians and the “Russian-speaking population” in Ukraine from ultranationalist fascists—apparently referring to the new government in Kiev, not himself. To this point, the free world’s response amounts to strongly worded condemnations and threatened sanctions.

Conflict in the Crimea is nothing new—or terribly surprising. The peninsula is home to the region’s only warm water port and has been coveted by various powers for centuries. Catherine the Great took it from the Ottoman Empire in 1783. The Ottomans, British and French fought a bloody war against Russia over it in the 1850s. And it was part of the Russian state until 1954, when Ukraine-born Soviet Premier Nikita Khrushchev symbolically gave it to Ukraine—Ukraine was part of the USSR, so it didn’t matter. After the Soviet Union broke up, Crimea remained part of Ukraine, with an agreement allowing Russia to continue stationing the Black Sea Fleet at the port (its home since Catherine the Great). According to Wikileaks cables, Putin has long viewed Ukraine’s claim on the peninsula as a sham, calling the country’s borders “sewn together” after WWII. After a pro-Western interim government replaced his puppet, Yanukovich, last week—largely ending Russia’s hopes of adopting the Ukraine into a Eurasian “customs union” (think USSR-lite)—a Crimean invasion was only a matter of time.

It’s also the sort of localized skirmish markets know well. It’s on European soil, but in terms of scope, it doesn’t differ much from Russia’s similar invasion of Georgian territories South Ossetia and Abkhazia in 2008 or the many Middle Eastern skirmishes that have raged for decades—incidents without lasting market impact. The Georgian crisis, which occurred during August 2008, coincided with significant global volatility, but this was more to do with the escalation of the global financial crisis—this was right around when Fannie and Freddie were going under. The Bosnian War in the early-mid 1990s saw some volatility—particularly after NATO authorized air strikes—but markets rallied well before the conflict ended. Neither the Israel-Hezbollah conflict in 2006, first or second Iraq war, the Syrian conflict, Egypt’s revolution nor any modern Middle Eastern conflict has caused a bear market. Same goes for the Korean and Vietnam Wars. By contrast, the Nazi invasion of the Sudetenland in 1938 made it clear appeasement couldn’t contain Hitler’s territorial ambitions, forcing markets to start pricing in a major global event.

For investors, there are two key questions about the Ukraine situation. One: What is the potential economic impact? Two: What is the likelihood the world’s major powers get drawn into an armed conflict?

The answer to Question One is, Small. With annual GDP of about $176 billion, the Ukraine is about 0.2% of the world’s economy. It is Europe’s breadbasket and home to a major pipeline system transmitting Russian natural gas to Europe. But the region has many other sources of grain, and European nations have been purchasing increasingly more fuel from Norway. Ukraine’s financial markets are reeling, especially with Russia now reneging on its late-2013 bailout pledges, but the IMF, US and EU are working on a deal to help bring the nation back from the brink of default. Russian markets are reeling, too—Russian stocks fell over 12% on Monday, the ruble tanked, and the central bank hiked short rates to 7% to stem the freefall—as investors consider the economic implications of potential sanctions.

However, the measures announced so far have little bite. The US made the strongest threats, but the US-Russia trade relationship is tiny—it represents about 1% of total US trade and 4.4% of total Russian trade. The US has enough spare natural gas to undercut Russia’s dominance in Europe, but it doesn’t yet have the infrastructure for transatlantic LNG exports. Aggressive or no, US economic measures likely aren’t going to hit Russia hard in the here-and-now.

Economic sanctions from the EU would do serious damage, but to both sides, likely explaining French and German opposition to sweeping measures. Even after accounting for recent supplier shifts to Norway, a third of European natural gas is imported from Russia. Russia also supplies 34.5% of the EU’s oil and 27.1% of hard coal imports. The EU is hedged against this to an extent through inflated gas reserves, but reserves are not infinite. Hence, the only concrete measure under EU consideration is an arms embargo, which would be symbolic at best. Longer-term, these events might put Russian energy giant Gazprom at risk—especially if shale exploration in Poland speeds up—but for now, the likelihood Russian weakness takes a huge bite out of global GDP is exceedingly low.

As is the likelihood of sweeping global military action. Headlines draw Cold War parallels, but in reality, all that means is East and West are arguing. The US has already ruled out military action, opting instead for a broadside of angry adverbs. NATO isn’t mobilizing (except for a handful of international observers). The UN isn’t sending peacekeepers. Considering economic sanctions are struggling in the bureaucratic morass that is the European Union, our guess is EU troops don’t go anywhere, either. Monday’s meeting of EU foreign ministers yielded only a threat to “decide about consequences for bilateral relations” if Russia doesn’t “de-escalate.” In short, it would take something huge, unexpected and unprecedented in the Putin era for this to escalate in something more than a diplomatic standoff. Absent Putin doing the unthinkable, the West’s weapons of choice likely remain the standard televised warnings and condemnations, red lines and strongly worded letters.

And if it stops there, for markets, the skirmish shouldn’t do lasting damage—1936, which featured a similar yet arguably more tense global political environment, saw double-digit returns. If the US and EU did get drawn into a big military conflict with Russia, it would be a negative—but again, at a time when the West’s biggest salvo is boycotting the G-8 Summit in Russia, and even economic actions don’t take flight, there is almost no chance this conflict goes global.