The major international headlines around the world are currently dominated by what Russian premier Vladimir Putin plans to do with his neighbor to the southwest, Ukraine. A former Soviet Union satellite nation and dominantly Russian speaking country, Ukraine is caught in the crosshairs between two ideologies as both a resource-rich and strategically important country situated between Russia and Eastern Europe. This week’s blog will take a short dive into how things may unfold and what that may mean for your money!
Why is Ukraine Important?
Ukraine is situated directly to the south of Russia. Since the fall of the Soviet Union, most of the countries that were under their “sphere of influence” have joined NATO, a defensive alliance of Western European countries (e.g. France, Germany, the U.K.), the U.S., and Canada. Russia has resented this alliance’s inclusion of countries further east because it allows NATO to put defensive military installations in place in those countries. Ukraine as a country has migrated further away from Russian influence, and Russian fear is that Ukraine will join NATO and will allow them to position even closer to the direct Russian border. Russia views Ukraine as a part of Russia’s historical land footprint and has kept strong influence in the country’s politics since they declared independence at the end of the Soviet Union.
By geography, Ukraine is the second-largest European country (after Russia, which is considered European). Ukraine is very rich in both oil and natural gas resources and is situated in a key position to supply gas to Western European countries. Russia currently supplies about a third of Europe’s overall natural gas and has agreed with Germany to build a pipeline called Nordstream 2. This pipeline would be very important to Russia because it has to pay transit fees to Ukraine for the current gas to pass through the country.
How Does a Land War In Europe Affect the U.S. Markets?
Most of the time, when there is conflict internationally, the global markets tend to shrug it off after an initial drop in asset prices. However, Russia invading Ukraine would constitute the largest land war in Europe since World War 2 almost 80 years ago. On this scale, it would have the potential to affect many aspects of the overall global market. I’m going to focus on how it could potentially affect us, assuming that we stay militarily out of the conflict. I believe it affects two key themes in the current market environment: U.S. inflation and the path of interest rates.
Inflation: The last CPI reading (a measure of inflation estimation used by economists) in January indicated a rate of 7.5% inflation measure year over year, one of the highest readings we have seen since the 1980’s. If Russia invades Ukraine, the most predictable outcome would be for the U.S. and partner countries to impose severe economic sanctions on Russia. This would almost certainly include reducing or eliminating trade with them. This harms the Russian economy in particular by not allowing them to sell their most important resource: oil and gas. The U.S. would have to tap other resources and trading partners to fill that need, and Europe may not completely be able to get away from buying Russian energy, but could certainly reduce it. This would drive prices up for both oil and gas. In the U.S., where we already are experiencing record inflation levels for our time period, this would likely increase those pressures.
Interest Rates: The Fed has indicated it is positioned to combat inflation by beginning to raise short-term interest rates, and speculation has been rampant as to how aggressive they can be. If inflation is pressured by the sanctions on Russia following an invasion, there will be added pressure on the Fed to raise rates to combat it. This has led to a lot of variation in market-followers as to how much the Fed will raise rates in 2022. Estimates vary between 2 to 7 rate hikes, which is an abnormally large gap in estimates. How the Fed responds to changes in inflationary pressures will dictate the direction on markets for this entire year.
How Are We Approaching This?
Portfolios vary widely between different investor risk tolerances and situations, so it’s hard to say with certainty what a specific individual should do in their situation. However, as this situation unfolds, I believe it’s reasonable to expect the following:
(note: the following are my own OPINIONS on potential market direction and should not be taken as factual information)
- Energy: I believe that strength in the energy sector of our markets will continue, and the price of oil will continue to rise. Any sanctions on Russian markets must include the biggest portion of their economy to be effective.
- Fixed Income: Weakness in bonds will continue. On the short end of the curve, the Fed raising rates will limit bond upside for some time until we get a better feel that inflation is coming back under control. For longer-term bonds, as the Fed ends their easing program, there may be some upward pressure on rates on the long end. As rates rise for bonds, prices of those bonds fall. I don’t expect aggressive moves on rates for longer term yields, but prices of bonds move more for the same rate increase on the long maturities, so it doesn’t take a large move in those rates to create a capital loss.
- Equities: The overall market is likely to stay volatile as things are figured out with inflation. The market still has no certainty over how the Fed intends to raise rates, and the market hates uncertainty. It’s reasonable to expect that overall the market will move up and down deciding on direction. However, within the market there are likely to be winners in individual sectors of the market. For example, financial institutions like banks are generally comfortable with steady rate increases, as it helps their overall profit margins on loans and deposits.
Thanks for taking the time to read the blog this week! If you have questions, or want to review your portfolio in more detail, please reach out to me! I specialize in creating focused, interactive plans for clients building wealth for retirement as well as managing those retirement plans to make sure my clients enjoy their retirement years to the fullest. I also work with a variety of other financial issues! If you would like to schedule a free consultation, please call my office at the number below, or click the link to schedule a virtual or in-person meeting (or phone call) by setting a time that works for you! I would love to hear from you! Enjoy the rest of your week!
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Mitch Bodenmiller
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