Counsel Views – Special report on the Russian invasion of Ukraine

Good day, everyone. Thanks for joining me on this podcast where I’m going to provide some colour on the most recent events in Ukraine on February 24, 2022. I’m going to break down what’s happened recently, the impact on the markets so far; provide some context as to how markets have reacted to such events in the past; and then wrap up with how we’re thinking about portfolio management.

So, what do we know so far? Russian President Putin ordered an invasion of Ukraine following earlier warnings from U.S. officials that such an operation would happen imminently. Western powers are poised to impose more punitive sanctions today on Moscow in an effort to effectively sever the country’s access to global capital markets; with the notable exception of the Nord Stream 2 pipeline project, which has already been halted. The White House has really gone to lengths to convey it’s not going to target the Russian energy sector and exacerbate an already tight supply situation.

In our last podcast, we did talk about how Russia would wait for the Beijing Winter Olympics to be over before invading Ukraine, so not to take the spotlight away from China’s moment. So not entirely surprising that just one day after the regular session of the Winter Olympics was over, Putin wasted no time in having the Russian Parliament rubberstamp the declaration of two Ukrainian separatist regions.

So what’s been the impact so far on financial markets? It’s early days but, clearly, risk-off in markets where we’re seeing equity markets down and bond prices up. So far, a sharp decline in European equity indices in the early mornings, but that’s to be expected given proximity to the conflict. The bond markets similarly reacting in expected risk-off mode. We’re seeing government bond yields decline in Germany and the UK and Japan.

Investors are seeking flight-to-safety in U.S. treasuries. The U.S. 10-year yield is back below 1.85% at the time of recording, which is significantly lower than being above 2% earlier this year. We’re seeing strength in the U.S. dollar and, of course, gold is also rallying on this event in news and continuing on its course since the beginning of the year. Crude oil is sharply higher, of course, as well, and seeing energy markets continuing to perform as they have since the better part of the end of 2021.

Past performance is never a guarantee of future performance, of course, but how have financial markets historically responded to acts of war. Surprisingly, the number of days that the U.S. equity market has been down as a result of acts of war has been quite short.

In the 28 past bouts of geopolitical-related selloffs, if we go back to World War II, the S&P 500 took about 3 weeks to find a bottom and another 3 to bounce back to—after a median drop of about 5.7% to similar types of events. And that’s not to say drawdowns and subsequent recoveries haven’t been longer or shorter, of course. For instance, during the Iraq invasion of Kuwait in August 1990, the U.S. equity market declined 18% over 51 days and it took 138 days to recover that loss. Going back a bit further, when Japan attacked Pearl Harbor in December 1941, the U.S. equity market declined 8.2% over 12 days, and then took another 240 days to recover those losses. If we go back to the last Russia invasion in Crimea in 2014, we did see U.S. markets down just one day, just under 1%, and it took two days to recover those losses.

Of course, this conflict is unique in many respects. Given the inflation risks we’ve been talking about, financial conditions generally have been tightening; and all accounts that the sanctions against Russia and the fallout in the energy markets may take markets on a different course from history. Or they may not.

As a result of rising commodities and key fiscal reforms, Russia has been able to build a substantial foreign exchange and sovereign wealth fund war chest. Its international reserves currently stand at about U.S.$630 billion, which is the highest level ever. And that potentially gives them additional bandwidth to withstand Western sanctions and a potential loss of export revenue.

So, we’ll continue to watch these events and how they impact treasury and credit markets and look for signs of weakness in both liquidity and credit.

What’s the potential fallout on global central bank tightening policies? Because this leads back into what’s been sort of the key marquee risk in markets, at least over the last few months. And the stagflationary energy shocks, so inflation higher, real incomes and real activity lower, and the risk of sanction disruptions come at a time when central banks are already trying to manage the pandemic-driven inflation surge. So, this will likely cause a shock to commodity prices and potentially more inflation pressures and then more persistent elevated inflation to come.

As well, we’ve seen early signs that liquidity in financial markets has been a growing concern as tightening conditions have been building up over the last few months. And I think that’s exactly what Fed officials and other central banks will be watching for in order to see whether or not bond and money markets are functioning properly in light of this heightened volatility and risk. And if we just go on history, we know that liquidity risks will take precedent over inflation risk as the liquidity threat certainly could fast-forward recession scenarios for global central bank officials.

So, I think the market will eventually take comfort in knowing that the Fed and other global central banks will not let liquidity risk escalate amidst this crisis. Already we’ve seen in early press reports, European Central Bank and Bank of Japan officials taking note of the Ukraine situation and looking to support markets where needed. Furthermore, it’s reasonable to expect Fed officials to comment in the press over the coming days and weeks about how they’re thinking about policy and liquidity in light of the Ukraine invasion.

Markets are going to be on the lookout for potential signs of a dovish Fed over the coming days to calm down markets and bond markets. Either way, the next event everyone’s going to be watching for is in mid-March at the next Federal Open Market Committee meeting, where it’s expected the Fed’s going to raise rates at least 25 basis points. I think that’s a foregone conclusion. So what investors will care most about will be the colour commentary around plans for additional rate hikes and balance sheet reduction, both in terms of timing and magnitude.

So, given all this, how are we thinking about portfolio management? We’re not making any sudden moves here. It’s very early days and, historically, geopolitical events have rarely knocked markets off their path for very long periods of time, as we’ve discussed.

It’s important to remember, we’re often our own worst enemies at times, and thinking about your investment portfolio from one day to the next has never been a sound investment strategy to build wealth over the long term. Empirical research tells us that the average investor tends to materially underperform the average investment fund over time, and that underperformance is usually a result of our own or investor’s behaviour.

At RBC PH&N Investment Counsel, we believe that being prepared for what may lie ahead is a better strategy than trying to predict the future. So, talking about time in the markets versus timing the markets we believe has always been a winning strategy over the long run. And it’s really at times like this where we affirm why we build these diversified portfolios for clients and maintain this risk management discipline above all else.

So as the situation in Ukraine continues to evolve, we’ll keep you informed as to our latest views and thoughts about the market. And as always, if you have any questions or concerns about what you’ve heard here today or about your portfolio, please contact your investment counsellor with any questions.

Take care and bye for now.