Markets weigh Russian threat to Ukraine

ECONOMY AND POLICY

February 16, 2022

Developments on the ground in Ukraine may mean more than official statements.

With markets focused on the potential for near-term escalation in Eastern Europe, investors are considering the implications should Russia conduct a significant military operation against Ukraine. “A diplomatic path still appears open, but elevated risk of escalation and high uncertainty remains,” said Ed Mills, managing director of Washington policy at Raymond James. President Joe Biden said on February 15 that the United States is “prepared for every scenario.”

Headlines pointed to potentially de-escalatory signals coming from the Russian government, but developments on the ground may be the more reliable indicators in the days and weeks ahead. Analysts also note that the public, long-running nature of the current military buildup sets up a scenario where surprise and concealed operations begin with little or no notice, similar to how events played out with Russia’s actions against Crimea in 2014.

Effects of sanctions 

U.S. policymakers have signaled sanctions would be swiftly implemented in response to Russian military action with tightened export controls on semiconductors made both by U.S. companies and those made overseas with U.S. equipment in the production process. “Effectively, this would cut Russia’s access to leading microchips and reduce Russia’s ability to function as a modern economy if broadly implemented, rather than targeted at strategic sectors,” Mills said.

Financial sanctions levied against core Russian banks and key materials companies, as signaled under a draft sanctions package in Congress, would place European banks at the epicenter of impact of new sanctions given they are largely more intertwined with Russia’s economy than U.S. banks. With commodities, a spike in natural gas prices could be seen with real questions about Europe’s ability to replace supply. The Biden administration has been working with U.S. suppliers and allied nations to direct more energy shipments to Europe to offset the impact of a potential shortage and deny Russia the flow of capital from exports.

Domestic policy impact 

Elevated geopolitical risk could increase doubts about the Federal Reserve’s (the Fed) planned timeline for raising the federal funds rate as the situation unfolds. In such a scenario, expectations for the number and speed of rate hikes could be scaled back for 2022. More focus could also shift to how the Fed manages the balance sheet to influence the rate curve. In the longer term, Russia’s actions may affect the midterm elections. Typically, in the event of a foreign crisis, we see a “rally around the flag” moment in support of U.S. foreign policy. This dynamic is largely absent from the current situation, where partisan division continues to dominate the narrative.

“There is a real risk for Democrats that Russian aggression advances a narrative of foreign policy missteps that led to the precipitous drop in President Biden’s approval ratings following the U.S. withdrawal from Afghanistan,” Mills said. “Politically, this could drive general voter sentiment that the U.S. is on the wrong track under Democratic leadership on foreign policy, limiting the ability of Democratic candidates to win close elections in the fall.”

However, polling indicates a generational divide around the role the U.S. should play, with younger voters (under 44) leaning toward noninvolvement while older voters (65+) favor supporting Ukraine against Russia. If there is a “rally around the flag” moment with escalating conflict, impact could come from older voters, who disproportionally indicate a desire for the U.S. to support Ukraine.

A risk-off event  

From a market perspective, Russian escalation against Ukraine is a “risk-off” event for equity and credit markets globally, likely driving Treasury yields lower, especially at the longer end of the curve. Here are some key points from Raymond James Equity analysts:

• Sustained fear of escalation could make a pullback worse in cyclical stocks (except for energy) and investors might rush into big-cap tech as a “safe haven” trade.
• Investing in Europe and Asia may become less appetizing if natural gas prices remain high or go even higher.
• The obvious beneficiary from a near-term stock perspective is the energy sector, on higher oil and natural gas prices.

Market uncertainty and volatility could increase investors’ concerns about their portfolios. As markets react to geopolitical events, it is important for investors to maintain a long-term perspective and consult their advisors before taking action.  

All investments are subject to risk, including loss. All expressions of opinion reflect the judgment of the author and are subject to change. There is no assurance the trends mentioned will continue or that the forecasts discussed will be realized. Past performance may not be indicative of future results. Economic and market conditions are subject to change.