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The escalation in Ukraine tensions: Implications for investors

Key Points 

  • Ukraine tensions have escalated with Russia ordering troops into Ukraine regions already occupied by Russian separatists. 
  • Share markets are at high risk of more downside on fear of further escalation and uncertainty about sanctions/gas supply to Europe. 
  • The history of crisis events typically shows a short term hit to markets followed by a rebound over 3 to twelve months. 
  • Given the difficulty in timing market reactions to geopolitical developments, the best approach for most investors is to stick to an appropriate long term investment strategy. 
Introduction
The last few days have seen a sharp escalation in the situation between Russia and Ukraine, with Russia  recognising the independence of two regions in the Donbas area of eastern Ukraine controlled by Russian  separatists and ordering Russian “peacekeeping” troops into the regions. 

At this stage it’s unclear how big the force will be, whether it will push beyond the areas controlled by  the separatists and, if so, how far. Although President Putin continues to deny plans to invade Ukraine,  his comments suggest a move into the areas of Donetsk and Luhansk in the Donbas that the rebels do  not yet control.  As a result, share markets have fallen further with US and global shares falling just below their January  lows and Australian shares also under pressure, although so far they have held up a bit better.

Bond yields have also fallen due to “safe haven” demand and oil prices have pushed to new post 2014  highs. The market reaction reflects a combination of uncertainty around how far the conflict will go, with  Ukraine being Europe’s second biggest country (after Russia), the threat of further sanctions, and  uncertainty about how severe their economic impact will be. There is also the risk Russia cuts off its supply of gas to Europe where prices are already very high, with a  potential flow on to oil demand at a time when conflict may threaten supply. 

In short, investors are worried about a stagflationary shock to Europe and, to a lesser degree, the global  economy generally.
Possible scenarios 

Trying to work out which way this goes is not easy, but it seems there are four possible scenarios, some  of which may overlap:  Russia stands down. This would provide a brief boost for share markets, including Australian shares, (eg  +2 to +4%) as markets reverse recent falls that were driven by escalating tensions. 

Russia moves in to occupy the Donbas areas that are already controlled by Russian separatists with  sanctions from the West, but not so onerous that Russia cuts off gas to Europe. This could see a further  hit to markets (say -2%), although it looks like it may be getting close to priced-in.

This may be similar to what happened in the 2014 Ukraine crisis (with Crimea) and if that’s all that  happens then markets would soon forget about it and move on to other things. Much as occurred in  2014. 

Russian invasion of all of Ukraine with significant sanctions and Russia stopping gas to Europe but no  NATO military involvement. This would cause a stagflationary shock to Europe and to a lesser degree  globally, as oil prices rise further and could see a bigger hit to markets (say -10%) followed by a recovery  over six months.

Invasion of all of Ukraine with significant sanctions, gas supplies cut and NATO military involvement. This  could be a large negative for markets (say -15-20%) as war in Europe, albeit on its edge, fully reverses the  “peace dividend” that flowed from the end of the cold war in the 1990s. Markets may then take longer to  recover, say 6 to twelve months. 

Given the path Russia has gone down and the stridency of President Putin’s recent comments, Scenario 1 is looking less and less likely, but is still possible if there is a breakthrough in talks. 

Scenario 2 looks to be already on the way, with Putin ordering “peacekeeping” troops into the Donbas  region. This may be the “military-technical” action that Russia referred to last week. 

At the other extreme, it’s still hard to see Russia undertaking a full invasion of Ukraine given the huge  cost it would incur. And it’s hard to see NATO troops being involved, particularly given limited public  support for it in Europe and the US. 

The US has said US forces would not go into Ukraine. However, some combination of scenario 2 and 3 is  possible whereby the crisis escalates further, if say; the Donbas separatists and the Russian  “peacekeepers” push into Donbas territory that the separatists do not yet control and beyond. 

And of course, with Russian troops moving into the Donbas region of Ukraine, investment markets will  worry that we will move on to a wider invasion of Ukraine (until signs appear to the contrary). So we  could still see share markets fall further and oil prices rise further in the short term.

Crisis and and share markets 

Of course, there is a long history of various crisis events impacting share markets. This includes major  events in wars, terrorist attacks, financial crisis, and so on.

 

The pattern is pretty much the same for most events, with an initial sharp fall in the share market  followed by a rebound. Since World War Two the average decline has been 6%, but six months later the  share market is up 9% on average and 1 year later its up around 15%.

 

What does it all mean for investors? 

We don’t have a perfect crystal ball and its even hazier when it comes to events around wars. But from  the point of sensible long-term investing, the following points are always worth bearing in mind in times  of investment market uncertainty like the present:

  • Periodic sharp falls in share markets are healthy and normal, but with the long-term rising trend  ultimately resuming and shares providing higher long term returns than other more stable assets.
  • Selling shares or switching to a more conservative investment strategy after a major fall just locks  in a loss and trying to time the rebound is very hard such that many only get back in after the  market has recovered.
  • When shares fall, they are cheaper and offer higher long-term return prospects. So, the key is to  look for opportunities the pullback provides. It’s impossible to time the bottom but one way to  do it is to average in over time.
  • While shares have fallen, dividends from the market haven’t. Companies like to smooth their dividends over time. They never go up as much as earnings in the good times and so rarely fall as  much in the bad times. In the meantime, the income dividends provide is still being received.
  • Shares and other related assets bottom at the point of maximum bearishness, i.e. just when you  feel most negative towards them.

The best way to stick to an appropriate long-term investment strategy, let alone see the opportunities  that are thrown up in rough times, is to turn down.

Further information
If you have any queries relating to the above articles or any other financial planning queries, please contact the office on 03 9432 9611.

Source: Dr. Shane Oliver, Head of Investment Strategy and Economics and Chief Economist, AMP Capital. Gavin Melican is a Authorised Representative (No.385713) of Interprac Financial Planning Pty Ltd. Australian Financial Services Licence No. 1268416. Information contained in this document is of a general nature only. It does not constitute financial or taxation advice. The information does not take into account your objectives, needs and circumstances. We recommend that you obtain investment and taxation advice specific to your investment objectives, financial situation and particular needs before making any investment decision or acting on any of the information contained in this document. Subject to law, Interprac Financial Planning nor their directors, employees or authorised representatives gives any representation or warranty as to the reliability, accuracy or completeness of the information; or accepts any responsibility for any person acting, or refraining from acting, on the basis of the information contained in this document.

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