These kinds of geopolitical risks are hard for investors to analyse and any probabilities assigned to potential outcomes are little more than guesswork. Also, anything we write about them can become out of date very quickly, so they require constant attention.

Consequently, we believe it is appropriate to ensure investments decisions are driven by an approach designed around economic fundamentals.  All that said, we, of course, want to provide reassurance and context to clients about their portfolios in light of these geopolitical issues and therefore outline our views below.

Firstly, what are the potential outcomes from Russia building up troops on the border with Ukraine?

One, and we hope the most likely, is that diplomacy works, and that tensions de-escalate, though they may not completely go away. To work, diplomacy would require a joined-up strategy between the US and Europe. It would also help if China encouraged Russia to stand down its troops. If there is a diplomatic solution, we would expect Russian and Ukrainian equities, bonds and currencies to rally. Given that these are an immaterial component of client portfolios, the diplomatic solution should have little impact on portfolio values.

The second is that Russian troops make an incursion into Ukraine and the West responds to this by imposing sanctions on Russian individuals, businesses and the financial sector.

Russia could potentially also be locked out of the SWIFT network for sending payment orders between banks, which would affect Russia’s ability to trade with other countries. The problems with sanctions are that they are blunt instruments and can have unwelcome consequences. For instance, barring Russia from SWIFT could result in Russia stopping the flow of gas to Europe. It may also be hard to build a consensus on sanctions, with France and Germany much less keen on their use than the UK and US.

If an incursion by Russian troops leads to sanctions being employed, we think there is a reasonable chance that this deters further aggression but that troops remain stationed near the border and tensions stay high.

From a financial markets perspective, we would expect Russian and Ukrainian asset prices to fall further, and for risk assets in Europe and, to a lesser extent, the US, to fall slightly as investor risk appetite weakens. Share prices for banks may fall further, though energy companies could see their shares rally if oil and gas prices rise. Aerospace and defence stocks are also potential beneficiaries of increase military spending.

Developed market government bond prices could rise as yields fall on safe haven buying, though European bonds may be undermined if higher energy prices cause inflation expectations to rise. In this outcome, we would expect portfolios to feel some pain in the form of low-to-mid single digit losses, with government bonds and more defensive (plus energy) equities partially offsetting falls for more cyclical equities and credits.

The third potential outcome is a larger military conflict, if President Putin feels he cannot pull back Russian troops without losing face at home or if encouraged by Beijing that he has Chinese support in any conflict with the West.

As well as armed conflict, this would likely include less traditional means of attack, such as cyber warfare. Overt conflict would likely result in the full range of economic sanctions being deployed by the US and Europe, including bans on semiconductor sales to Russian businesses. US President Biden would be under immense pressure to respond with military force or be criticised as being out of his depth and face huge Democratic losses in the midterm elections in November.

War in Europe would likely seriously erode investor confidence, causing risk asset prices to fall sharply. Russian and Eastern European equities would certainly be hit hardest, though Western European markets would suffer due to their proximity to the conflict and the likelihood that the flow of gas from Russia is interrupted and energy prices soar. However, we would also expect Asian stock markets to weaken, with investor concerns about China invading Taiwan rising. Stock markets globally would likely see double digit declines, though a flight to safety should lift the prices of government bonds and gold. Credit markets would probably weaken, though we would expect swift intervention by global central banks to stabilise them.

Although the war scenario is very alarming for investors, we think it is, by far, the least likely outcome.

Unlike a brief incursion, which could be sold as a victory by President Putin, it is very hard for Russia to come out well from a war. The risk is that he miscalculates and assumes President Biden is too weak, and Europe too divided, to respond effectively. However, after the West’s muted response to the annexation of Crimea and the botched withdrawal of troops from Afghanistan, we hope lessons have been learned and that Western leaders will act decisively.

We therefore believe that, from an investor’s perspective, the tensions between Russia and the West over Ukraine will just be a temporary distraction before focus returns to the usual drivers of economic and market cycles – namely demand, supply and financial conditions. We are therefore not recommending taking any specific action relating to current geopolitical tensions.

If you would like to discuss this note or have any questions, please get in touch.

About The Author

Andrew Birt
Andrew is the Investment Director at Saunderson House and manages our team of in-house investment analysts. Andrew joined the ...
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