Market Update - Russia, markets and what history has taught us

Tuesday 22 February, 2022

Rising tensions over Russia and Ukraine have taken over as the dominant factor driving day to day movements in markets. Yesterday, Russia recognised the breakaway regions of Donetsk and Luhansk in the Donbas region of Ukraine and plans to send "peacekeeping" forces to the area. These areas were already controlled by pro-Russia militias, so this could be seen as confirming the status quo. On the other hand, it will be seen as provocative by Ukraine and its allies. Sanctions will be forthcoming but for now not on the scale that the US, UK and EU have threatened if it became a full invasion.   

This caused a drop in equity markets and a rally in US Treasury bonds yesterday afternoon, which has continued in the Asian session overnight. The biggest damage has been in Russia's own equity market with the MOEX index down 17% over yesterday and today (as at 7am GMT) ^[1]. The Ruble has also dropped, meaning the MOEX is down over 20% in Dollar terms[2]. Perhaps this demonstrates that the damage to the Russian economy may be worse than the damage done to the rest of the world.   

An invasion of Ukraine would most likely see oil and gas prices continue to rise and the stock market to fall further. How far and how deep would depend to some extent on how far it goes. It seems unlikely that NATO forces would get involved directly in any fighting. Russia may settle for what it did yesterday, recognising the pro-Russia separatist regions of Donetsk and Luhansk and putting Russian troops on the ground in this Russian speaking region. This would be symbolic but would, as we said earlier, do little more than recognise the status quo. While this region has a very high ethnic Russian population, a much larger part of Southern and Eastern Ukraine has a majority of Russian speaking population. This could apply to most of the regions west of the Dnieper river that runs south from Belarus through Kiev before turning west to come out into the Black Sea northwest of the Crimean Peninsula.   

Russia's main concern has been the expansion of NATO into what it sees as its sphere of influence, but it has also been keen to support ethnic Russians in Ukraine. This may be the excuse for a full invasion which would be the biggest war in Europe since 1945. 

These are dark times and when trying to understand the implications, we tend to look for historic comparisons. There is nothing that compares directly but we have looked at the Cuban Missile crisis of 1962 for US/Russia tensions and the Iraq invasion of Kuwait for oil supply disruption to try and tried to put this into some historic context. 

Firstly, we would stress that a de-escalation of the tensions around Ukraine would be best for all parties and diplomacy may yet bring that to the fore. Secondly, today’s circumstances are very different - the Cuban missile crisis threatened a direct confrontation between two major Nuclear powers and the destruction of life as we know it. President Biden has made it clear that direct fighting between the US and Russia is unthinkable and that US forces will not fight in Ukraine. It would result in sanctions which could see Russian oil and gas supplies cut off which is why it is somewhat comparable to Kuwait, which threatened disruption in supply of oil from the gulf. 

The Cuban missile crisis took place between 16th October and 20th November 1962. This was after a sustained rally through the 50s when the S&P peaked in 1961, then corrected 27% in what was known as the Kennedy slide - bottoming in June, it started to recover 14%[3]. It declined again but only fell 6% in the early days of the crisis before bouncing back. By September 1963, it was making a new high passing the 1961 peak. The market was helped by JFK who agreed to tax cuts and reduced margin requirements. 

The invasion of Kuwait came on the 2nd August 1990. Over the following weeks the oil price rose over 80% and the S&P fell 17%[4]. The S&P gradually recovered only dropping a little ahead of Operation Desert Storm, which when successful saw the oil price fall back, and the S&P recover by the end of 1991. At that time, it was 17% above the level pre the invasion[5]. All of this occurred despite a recession in the US from July 1990 to March 1991. Interest rates were cut from 8% to 4% to fight the recession[6]. 

Rate cuts on the scale of 1991 are not on the cards but despite higher energy and agricultural prices, the Federal Reserve would probably be reluctant to raise rates as fast as is priced into markets. The European economy would be hardest hit being dependent on Russian gas. However, European markets reflect this risk to some extent already. It should also be noted that while the oil price has risen steeply, the futures curve implies that the oil price is still expected to fall back later this year and into next year.   

We all hope that the Russians see the potential economic damage and that the diplomats find a way through the present crisis as they did in 1962.   

The Lonsdale/LGT Vestra Model Portfolios 

Risk assets within the Model Portfolios have sold off as tensions have ratcheted up, with long duration holdings being hit particularly hard. This has caused some clients invested in our High Risk portfolio to breach the 10% drawdown notification level.

In the lower risk portfolios, bonds have offered some protection, but rising interest rates have also caused some level of drawdown. Our selection of alternative assets that we have been adding to over the last 18 months has provided protection within the portfolios. The Ruffer Diversified Return fund has been a highlight due to its exposure to cyclical equities and protective strategies, causing the fund to gain in excess of 4% since the start of the year[7].  

Recent trades have focused on adding robustness to portfolios, particularly at lower risk levels where we have reduced exposure to high Beta funds in the face of elevated volatility. However, we continue to favour high quality equities with wide economic moats that we believe will continue to outperform over the long-term. Whilst they may have sold off over the short term, fundamentals remain strong and buying opportunities exist for quality, active managers. 

Important information 

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The information and opinions expressed herein are based on current public information we believe to be reliable; but we do not represent that they are accurate or complete, and they should not be relied upon as such. Any information herein is given in good faith, but is subject to change without notice. No liability is accepted whatsoever by Lonsdale Services or its employees and associated companies for any direct or consequential loss arising from this document. This document is not for distribution outside of the United Kingdom. 

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Sources 

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[1] Factset as at 22.02.22 

[2] Factset as at 22.02.22 

[3] Bloomberg 

[4] Bloomberg 

[5] Bloomberg 

[6] Bloomberg 

[7] Factset as at 22.02.22 

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