Russia’s Symbolic Downgrade

Standard and Poor’s added to its long-running list of less-than-timely credit downgrades on Friday, demoting Russia to BBB-, just one notch above junk. Its rationale? Escalating tensions with Ukraine, which could invite sanctions and trigger capital flight. In the annals of backward-looking ratings agency decisions, this is one of the most striking—S&P merely acknowledged what markets have known for months. Even with the latest escalation in tensions, there was nothing fundamentally new to warrant a downgrade now versus months ago—something we’d suggest investors keep in mind as they consider the conflict’s market impact.

S&P tried to couch the decision in forward-looking terms, but the fundamental factors have been there for months. They claim Russo-Ukrainian tensions likely spur capital outflows, challenging an already weakening economy. But Russian capital flight is nothing new. While Russia experienced heavier capital outflows over the last three months ($63.7 billion), investors have been pulling their money for years ($62.7 billion in 2013 and $54.6 billion in 2012). The conflict, too, is well-known—and remains the sort of localized skirmish markets have ably dealt with for decades.

That’s true even with the latest developments. The situation in Eastern Ukraine, though terrible for the lives, property and freedom of those impacted, isn’t much of a departure from what we’ve seen since the first suspiciously dressed commandos appeared in Crimea. In recent weeks, well-organized, well-armed militants with insignia-free but otherwise identical-to-Russian uniforms have stormed and occupied government buildings, seizing control in ten cities. Local witnesses claim the men are new to town and speak with foreign accents. Vladimir Putin denies they’re envoys from the Motherland, but he said the same thing about the seemingly identical militia that took over Crimea—which he eventually admitted were Russian after weeks of denial.

Not wanting to rock the boat, Kiev’s interim leadership let Russia’s annexation of Crimea occur without military opposition, but this time, they’re defending their sovereign territory, launching an “anti-terrorist operation.” While shots were fired within Eastern Ukraine, Russia and NATO appeared to mobilize troops just outside the border (officially described as normal drills). But as tensions seemed to near the boiling point, the EU, Russia, Ukraine and US came to an agreement in Geneva to diffuse the situation on April 17—calling for protestors to give up their weapons and return all seized buildings to Ukrainian authorities in exchange for Kiev’s pledges to grant the region more autonomy.

Hopes were high for peace, but there isn’t much evidence anyone on the ground followed the agreement. Both sides have fired shots and taken casualties. Russia launched “new” military drills as Putin warned: “If the Kiev government is using the army against its own people this is clearly a grave crime,” and Russian Foreign Minister Sergey Lavrov threatened, “Russian citizens being attacked is an attack against the Russian Federation.” (Err ... not that he’s admitting the soldiers’ nationality.) On April 25, Pro-Russian militants kidnapped EU military observers—there under the Geneva accord—claiming they were NATO spies. Monday, the US imposed another round of sanctions on Russia in response, targeting seven Russian officials and 17 companies.

In short, things are getting more heated, and where this ends no one can say with certainty—an outright Russian invasion of Ukraine isn’t impossible, nor is NATO intervention. But while this would be a broader conflict than we’ve seen thus far—and terrible for everyone impacted—from markets’ standpoint, it wouldn’t be much of a shift from what has already occurred. It’s still a localized conflict, still concentrated in an area very small economically, and still exceedingly unlikely to turn into a huge, global war. It might feel more sensitive due to the major powers involved, but markets are well used to world powers trying to exert influence over their smaller neighbors. This conflict itself is new, but the principle is as old as time. Regardless of how you feel about Russia’s actions, they aren’t at all unique in history.

And they aren’t likely to lead to anything beyond regional hostilities—even if the West gets involved on Ukrainian soil, the violence would have to extend far, far beyond its borders for markets to be meaningfully moved over time. From the Bay of Pigs to the Iran/Iraq war, the first and second gulf wars, the Israel/Hezbollah conflict in 2006, the Bosnian War and Syria’s ongoing civil war—and everything in between—localized conflicts haven’t ended bull markets. Only the onset of World War II in 1938 did—a fully global conflict.

Could Russia’s spat with Ukraine go global? Anything is possible, but markets move most, over time, on probabilities—and there is almost zero probability of conflict spilling over into the EU and we sincerely doubt the West is going to launch an invasion of Russia. Saber rattling continues, but all sides are verbally committed to pursuing a diplomatic solution. Sanctions likely escalate along with rhetoric, but we’re still looking at symbolic measures targeting a handful of Russian companies and a few dozen individuals—individuals who’ve known for weeks sanctions are possible and have had plenty of time to pre-empt asset freezes. Even more sweeping measures targeting entire sectors likely don’t carry an outsized economic impact globally.

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