Russia’s War Against Ukraine Changes the Economic Landscape

Market Reaction: February 25, 2022

Highlights

KEY THOUGHTS

Russian missiles have struck numerous targets inside Ukraine today, with news reports of tanks advancing toward the capital Kiev and numerous casualties. It is now far more likely that Russia’s movement to displace the Ukrainian government or annex the country will mark a historic turning point for European security.

There is severe uncertainty regarding the extent of the conflict itself, potential knock-on impacts on other regional disputes, unknown consequences as sanctions affect financial markets, a likely rise in cybersecurity intrusions, extension of supply chain disruptions and other inflationary impacts.

The likelihood of oil sanctions, Russian-imposed restrictions, or conflict driven damage to energy infrastructure has vaulted global crude oil by about 6% today, with Brent trading at $104. German 1-month natural gas futures were 33% higher today.

The severe worsening of global energy costs comes at an unusually difficult time. Higher energy costs are a large part of current inflationary pressures post-Covid. Prior to the war, monetary policy in developed economies was about to turn from maximum accommodation toward tightening. Greater uncertainty and vulnerability in financial markets may weigh on the timing and pace of Fed tightening steps despite the inflation rise. It is possible that inflation prints will be higher than expected as they raise rates.

When the Fed acts, economic growth rates may already be heading downward at a higher than anticipated rate presently. Fiscal support for consumers will no longer exist and the negative impact of inflation on their wages will weigh on spending particularly in the US.

European growth rates will also be lower than expected as trade linkages to Russia and near-term energy supply problems will slow spending.

US bond yields have plunged 10-15 basis points across the yield curve on safe-haven inflows and the US dollar index has jumped nearly 1% today. However, the duration and extent of any rate impacts are unknowable at this moment.

The history of “geopolitical” conflicts suggest that global markets will initially trade with extremely high correlation - low levels of discrimination between the most impacted and least impacted assets. Whether broad markets have over-reacted or under-reacted depends on subsequent events.

To the extent the Russian invasion is viewed as “regional”, the global impacts may abate (see Figures 2-4.) The most prominent pattern is for economic shocks to manifest regionally, not globally. Only 3 events since WWII have sunk the entire world economy (the OPEC embargo of 1974, the Global Financial Crisis and COVID).

Investor preparation – in the form of asset allocation, regional diversification and hedging prior to the shock – could help portfolios. Reacting to lower asset prices by selling assets in the aftermath of a shock typically reduces returns. In the average of 20 geopolitical shocks since WWII, 1-month equity returns following an initial drop were positive (see figure 1).

Now that Putin has made his choice in Ukraine and NATO responds, well-diversified investors should seek to identify markets that have overreacted when considering future investment actions.

Figure 1: Geopolitical shocks have only driven turning points for the world economy twice since WWII
  S&P 500 (% since event date) Crude Oil (% since event date) MSCI World ex USA (%since event date) DXY Dollar Index
Geopolitical Event Date Initial Reaction 30 days 90 days Initial Reaction 30 days 90 days Initial Reaction 30 days 90 days Initial Reaction 30 days 90 days
Pearl Harbor 12/7/1941 -6.87 -2.90 -12.02
Cuban Missile Crisis 10/19/1962 -3.78 7.61 17.16
JFK Assassination 11/21/1963 -2.81 3.06 8.28
US Bombs Cambodia 4/29/1970 -15.30 -6.43 -4.94 0.00 0.00 0.00 -10.45 -17.01 -16.07 -0.20 -0.23 -0.51
Arab Oil Embargo 10/18/1973 -16.26 -5.61 -15.11 67.44 72.09 287.04 -14.86 1.96 -18.53 6.98 4.68 12.31
USSR Invades Afghanistan 12/24/1979 -2.27 5.37 -7.78 8.33 8.33 8.33 3.94 3.94 11.85 -1.06 -0.71 5.91
US Bombs Libya 4/15/1986 2.95 -1.39 0.16 -3.91 8.70 -15.65 0.00 6.19 8.16 -4.15 -4.80 -5.30
US Invades Panama 12/15/1989 -2.06 -3.73 -3.43 2.82 5.08 -6.21 0.00 3.67 -7.04 0.31 -1.69 -0.44
Gulf War 12/24/1990 -4.16 0.09 12.10 17.75 -20.67 -31.32 1.75 1.75 15.96 -0.21 -3.61 4.90
World Trade Center Bombing 2/26/1993 -0.31 1.67 2.04 -0.18 -3.44 -5.81 0.00 8.52 18.62 0.18 -1.15 -4.79
911 9/11/2001 -11.60 0.45 4.34 -4.09 -17.68 -31.98 -8.48 3.24 5.48 -1.08 0.29 1.85
US Invasion Of Iraq 3/20/2003 2.49 2.06 15.57 -8.16 -5.86 -6.54 1.53 4.58 22.05 0.84 -1.85 -7.89
Russian Annexation of Crimea 2/26/2014 1.16 0.68 3.62 -3.77 -2.43 -0.92 -2.42 -0.45 3.25 -0.40 -0.31 -0.10
North Korea Related
Korean War 6/23/1950 -12.80 -8.67 1.20
Operation Paul Bunyan 8/18/1976 -3.15 1.64 -4.32 0.00 0.00 0.00 0.00 -0.26 -7.60 0.07 -0.57 -0.12
2006 Nuclear test 10/9/2006 0.90 2.60 4.60 -1.46 1.09 -7.43 0.46 4.33 8.09 0.43 -1.32 -2.21
2009 Nuclear test 4/25/2009 -1.28 5.09 13.05 -3.73 19.56 36.56 -2.32 12.28 21.21 0.52 -5.54 -7.04
2013 Nuclear test 2/12/2013 0.02 2.88 7.53 -0.27 -8.18 -12.49 -0.99 1.15 5.73 0.59 3.12 3.96
2016 Nuclear test 9/9/2016 -2.55 -0.81 2.97 -3.38 14.12 16.54 -2.06 -0.81 -0.72 -0.01 1.36 6.05
2017 Escalation 8/7/2017 -0.24 -0.64 4.44 2.19 7.00 21.65 -0.26 -0.49 3.60 0.23 -1.22 1.62
Missile test over Japan 8/28/2017 0.08 2.69 6.43 -0.83 10.37 23.06 -0.25 1.80 5.45 0.05 1.25 0.62
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This table shows how Geopolitical shocks have only driven turning points for the world economy twice since WWII.
Source: CGWI OCIS and Bloomberg as of Feb 22, 2022. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only. Past performance is no guarantee of future returns. Real results may vary.
Average Geopolitical Impact to the S&P 500 over the course of the first 90 days
S&P 500 Initial Impact % 30 Days % 90 Days %
Average all events -3.7 0.3 2.7
Average ex WW2 0.4 22.0 3.4
Average ex WW2 and Oil Embargo -2.9% 0.7 4.4
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This table shows how Geopolitical shocks have only driven turning points for the world economy twice since WWII
Source: CGWI OCIS and Bloomberg as of Feb 22, 2022. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only. Past performance is no guarantee of future returns. Real results may vary.
Figure 2: Regional contractions are far more common than global since WWII. The world economy as a whole shrank in only 3 cases: 1) 1974 OPEC oil embargo 2) 2009 GFC 3) COVID shock 2020
Figure 2: Regional contractions are far more common than global since WWII.
This graph shows how Regional contractions are far more common than global since WWII.
Source: Haver Analytics through February 22, 2022
Figure 3: Global vs local equity market returns in regional crisis years
Regional Crisis Return during first year of crisis (%)
Asian Crisis 1997 Asia
-28.3%
Global
15.0%
Latam Crisis 1998 Latam
-35.1%
Global
22.0%
EU Crisis 2011-2013 Europe
-10.5%
Global
-6.9%
Commodity Collapse 2015 Latam
-30.8%
Global
-1.8%
US/China Trade War 2018 China
-18.7%
Global
-8.9%
Average -24.7% 3.9%
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This table shows the Global vs local equity market returns in regional crisis years
Source: Bloomberg and Citi Global Wealth Management Investments as of February 24, 2022. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only. Past performance is no guarantee of future returns. Real results may vary.
Figure 4: Initial reaction to a regional crisis across markets and period thereafter
Regional Returns following Russian Invasion of Crimea
Region Initial Reaction 1 Year Return
US 0.7% 14.1%
Japan -5.1% 24.4%
Europe -3.0% 14.1%
EM -0.2% 3.6%
Russia -11.8% -29.6%
This table shows the Initial reaction to a regional crisis across markets and period thereafter
Source: Bloomberg and Citi Global Wealth Management Investments as of February 24, 2022. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only. Past performance is no guarantee of future returns. Real results may vary.