Russia Invades Ukraine

The important story is not taking place on Wall Street

This article was originally posted on Sunday 27 February 2022, and was written over the weekend following Russia’s invasion of Ukraine on Friday 2.25. I have since made a few editorial changes to more clearly explain my thinking on that fateful Friday when Russia invaded Ukraine and the US stock market perversely went up significantly. But I have attempted not to change my commentary based on facts not available to me last Friday, and so what appears below still reflects my thinking—or more accurately my confusion—at that time.

As of today (March 1), the facts on the ground in Ukraine have changed significantly, with Russia’s invasion expanding in scope and ferocity and over 600,000 Ukrainian refugees fleeing the country. Europe and the US have implemented increasingly severe sanctions on the Russian financial system and the western alliance is increasing its military aid to Ukraine. The Russian rouble has plummeted in value, although with limited trading, the yield on Russian sovereign debt has skyrocketed and the Russian government has closed the stock market after it lost 40% or so of its value. The US and European stock markets have reversed course, with the European markets off significantly. The price on UST bonds has increased, with the 10-year yield falling to 1.72%. The USD has strengthened a bit vs the Euro (to $1.11) and the price of oil (WTI futures) is now at $105.. The financial press is publishing more articles about the likely economic impact of the sanctions on Russia, the possible global economic fallout from the invasion, and what all this means for the Fed and other central banks who were on their way to raising rates before Russia launched its invasion. Suffice it to say that the picture has changed significantly, but I think it is still interesting to ask ourselves why the markets have reacted the way they have over the past few days.

Revised article from Friday 25 February 2022

“Russia invaded Ukraine to start the biggest land war in Europe since Hitler… and U.S. stocks soared. What gives?” So begins an article from Friday’s WSJ by journalist James Mackintosh, someone whose views on the capital markets are always worth considering. Mr. Mackintosh was not the only person asking this question of course. So was I—in somewhat more colorful language—and so perhaps were many of you.

Russia’s invasion of Ukraine is a truly historic event which is still unfolding in real time, with potentially far-reaching and long-lasting global geopolitical ramifications. And so we should all be paying close attention to this story, but perhaps not by following it through the eyes of stock market traders and commentators as reported on Bloomberg and CNBC. The important story here is taking place on the ground in Ukraine, in the political capitals of the world’s major powers and in the head of Vladimir Putin. Developments in the capital markets are not unimportant, but they are not the main story (at least not so far).

I will leave it to Mr. Macintosh to explain better than I can why the US stock market did what it did last week—there are complex fundamental, technical and psychological aspects to his narrative—but I would like to add a bit of color and perspective which may help us all understand better what is happening in the capital markets and why this may or may not be a sign of things to come.

First, let’s recap what actually happened in the markets this past week, which isn’t entirely obvious from Mr. Macintosh’s article. The US markets were closed Monday for Presidents Day. The US stock market traded down 5% or so from Tuesday to the open on Thursday, as it became clear that Russia really was preparing to invade Ukraine. When Russia did in fact send troops into Ukraine, however, the stock market rallied strongly and by Friday’s close had recovered all of the week’s previous losses. And so over the course of the week in which Russia shocked the world by invading Ukraine, rocking the security foundations of the post-Cold War world, the US stock market was essentially unchanged. That is really quite remarkable under the circumstances, and it behoves us all to ask why?

In other parts of the world’s capital markets, the UST bond market traded up in price (down in yield) from Tuesday to Thursday and then reversed course on Friday, ending up essentially flat on the week (similar to what happened in US stocks). The US dollar initially strengthened against the Euro, by 2% or so, but then gave back half of its gains on Friday, ending the week at $1.12. And the price of oil increased to $95, up 5% or so.

In Russia, however, the capital market impact was much more significant, as one would expect. The Russian stock market lost half of its value through Thursday, but recovered 30% of the losses on Friday. Russian sovereign CDS spreads widened and the yield on Russian sovereign bonds jumped. The rouble lost 20% of its value against the USD through the end of the day Friday, despite intervention earlier in the week by the Russian central bank.

So how should we interpret last week’s capital market moves, and in particular those of the US stock market on Friday? Is the market telling us not to worry, that the future may look bleak for Russia and Ukraine but the economic damage to the US and the rest of the world will likely be contained? And if this is the case can we all now take a deep breath and relax a bit, knowing that the Fed and other central banks will once again have our collective backs if things remain rocky?

I am not generally a big believer in the predictive value of capital markets “signaling” in normal times, and I am even less of a fan in unprecedented times like these. Viewed over the course of four trading days, from Tuesday through Friday, the US capital markets were essentially unchanged (except for the price of oil), reflecting a rather benign initial view about the global economic impact of the Russia-Ukraine war outside of Russia itself. This strikes me as rather Pollyannaish, but perhaps the capital markets have a better perspective on these matters than I do. So what it is the capital markets may have seen that I don’t?

It is possible that the capital markets see a quick end to the Russian invasion, with very little collateral damage outside of Russia and Ukraine. I wish this were so, but it doesn’t seem consistent with the evolving facts on the ground as of Friday.

Or perhaps the capital markets think western sanctions will be slow to come together, will have little teeth (big loopholes) and will cause little collateral damage to Russia’s trading partners, particularly its energy consuming counter-parties in Western Europe, which may not be an unreasonable interpretation of historical western resolve or consensus.

It is also possible that by Friday investors had sharpened their pencils and concluded that Russia is just not that important to the global economy, at least not in the absence of a major prolonged interruption of Russian energy exports or substantial collateral damage from sanctions yet to be imposed.

And perhaps investors are betting that even if things get rocky as a result of the war, the Fed and other central banks will once again bail them out, if not by cutting rates then at least by pausing the widely expected increase in interest rates across the world.

All of these are possible explanations for last Friday’s strange market reaction to the Russian invasion of the Ukraine, and there may be other reasonable explanations as well. Perhaps the markets will wake up to reality over the weekend and trading next week will look very different than it did on Friday. And of course the facts on the ground will also change, hour by hour and day by day, which will also color the market’s evolving view on how all of this will play out.

But for now let’s look at a few numbers and try to put some of this into perspective.

The global capital markets are quite large, worth in excess of $250 trillion (combined global bond and stock market values), and it takes something pretty big to move them by even a few percentage points. The world’s economy is also quite large, with global GDP of over $80 trillion and US GDP approaching $25 trillion. And although Russia has the tenth largest economy in the world, its GDP is only $1.5 trillion—less than 2% of the global total and 6% or so of US GDP. In fact, the total GDP of Russia is less than that of several individual US states (CA, TX and NY). Ukraine’s GDP is even smaller, about 10% the size of Russia’s. And although Russia has extensive trading relationships with much of Western Europe, China is now Russia’s single largest trading partner and as we know China is sitting this one out. It is therefore possible that even a devastating and long-lasting impact of the war on the Russian and Ukrainian economies (tempered by support from China) might have only a relatively small or short-term impact on the rest of the global economy. Perhaps this is what the stock market was telling us—or hoping for— last Friday.

And although I am skeptical, this sort of narrative might be plausible but for two things: oil and nukes.

Oil and nukes. These are of course two very large ‘but fors’. Over 30% of Russia’s GDP is attributable to the oil and gas sector, as is 80% of its exports and the vast majority of its foreign currency reserves. (Russia also exports a lot of wheat, metals and other commodities.) Every major economy in the world relies on oil and gas to fuel its economy and Russia is a big player in this world market. And in Europe, the reliance on Russian hydrocarbons is particularly large and problematic for consumers, industry and governments. And the US is not immune to this risk. Even though we are not a big importer of Russian oil, a further increase in gasoline prices will certainly have knock-on economic and political impact here in the US.

And one can only guess at the geopolitical and economic impact in the unlikely event that Russia were in fact to deploy nuclear weapons in Ukraine (or elsewhere), as Putin has on several occasions suggested he might.

Or if China were to take this opportunity to heat things up a bit in Taiwan.

I do not know how any of this will play out in the days, weeks and months to come, and neither does the US stock market or anyone else. But it seems to me that it will be very hard to put Putin’s genie back in the bottle, as much as we might all like to do so, and the global effects of his actions in Ukraine could well prove to be significant economically as well as geopolitically, for many years to come. And even if the near-term economic impacts seem more or less manageable outside of Russia, investors’ risk aversion might well rise, at the same time as central banks tighten monetary policy, increasing the cost of capital and reducing economic activity and the market value of financial assets worldwide. This is not what the capital markets were signaling on Friday, at least not outside of Russia, but last week now seems like a long time ago. And Monday is the start of a new week, with who knows what in store for us.

But whatever happens in the capital markets in the coming weeks, let’s remember that the important story here is taking place on the ground in Ukraine and in the world’s political capitals, not on the floor of the world’s securities and commodities exchanges. And the heroes of this story will no doubt be the men, women and children of Ukraine, who have already inspired us all.

Links:

Why Stocks Rebounded After Russia Invaded Ukraine, WSJ, James Mackintosh 2.25.2022