Invasion of Ukraine by Russia creates huge volatility in all financial markets

 

The invasion of Ukraine by Russian military forces have dominated the headlines all around the world. 

The Russian ruble hit record lows on Monday while world stocks slid and oil prices jumped after the West ramped up sanctions against Moscow over its invasion of Ukraine, including blocking Russian banks from the SWIFT global payments system. Russia's central bank hiked its key interest rate to 20% from 9.5% and introduced some capital controls to bolster the ruble and fight inflation.

The Russian stock market has closed and remained shuttered since the start of the war and base on the write downs on Russian equities by the international finance markets, it is possible that the value of Russian stocks have lost as much as 50% of their value in the space of 2 weeks.

One month return of global markets

The fallout from tougher sanctions also rippled across financial markets outside Russia, especially in Europe

European banks were hit hard, with those most exposed to Russia as European banks are some of the largest holders of Russia financial instruments.

So far, the initial financial damage from the Russian sanctions to U.S. financial markets appears less than the worst fears.

The economic cost of Russia's assault on Ukraine was further exposed as the sanctions-hit country teetered on the brink of its first default on international debt since the Bolshevik revolution.

Moscow is due to pay $117 million in interest on two dollar-denominated sovereign bonds it sold in 2013. But the limits it now faces in making payments, and talk from the Kremlin that it might pay in rubles or China yuan, which will trigger a default by definition.  

Market watchers generally expect a default by Moscow to have a limited effect on the global financial system. Overseas investors hold a relatively small $20 billion in Russian foreign-currency sovereign debt. The worst hit sector in the fixed income category will probably be in the high yield bond category, though the impact is not really felt in the international high yield bond markets yet as the worst performing fixed income category still belongs to the Asian high yield bond due to its exposure to the China's property developer debt. 

The final impact of the default of Russian sovereign and corporate bond will leave even veteran investors guessing at what might happen. The greatest fear is a contagion effect across financial institutions due to derivatives that packaged Russian bonds and sold as a complete product to government and banking institutions.  

One month returns of bond markets

Gold and Oil prices have soared in the recent days but movement has been highly volatile as the western economies are now aggressively negotiating for increased production energy with other oil rich countries, resulting in oil price falling as fast as it went up. 

On the bright side, the Russian-Ukraine war will create a drag on the global economic growth as many companies have withdrawn from the Russian markets, which will result in a hit on their revenue in the coming quarters. The main impact is that the market will adjust its expectations of future US Federal Reserve rate hikes. That’s most apparent in the sharp drop in the yield of the two-year Treasury note, which is an indication that the Fed may not raise interest rates as quickly in order to balance between managing inflation and global economic slow down due to the war.

The conflict in Ukraine is still unfolding and the Russian war machine has grinded to a halt, without able to secure any of the major cities it needed for a decisive victory. The resolute resistance from the Ukrainian forces have rumored to have inflicted a huge amount of damage to the Russian army, which forces the Russian army to resort to blanket bombing of Ukrainian cities as it is reluctant to send boots into the major cities, which are now probably armed to the teeth without a great loss of manpower and equipment. This has result in a gradual softening of the Russian stance, with hope that there can be a resolution in weeks, so as to minimize the damage to the Russian economy and risk further damage to the Russian now diminished military reputation. 

Should the conflict dragged on, the financial markets will eventually adapt and move on. If the financial markets are able to survive two world wars, it should be able to survive this conflict, stronger and higher.

Portfolio Strategy

Markets are likely to remain choppy in the near term. While valuations have fallen and some risks have been priced into the market, it's not time to lower the risk of the portfolio. Base on historical precedents, investors trying to trade off geopolitical events can easily get whipsawed as sell-offs based on geopolitical events have been brief in the past. 

The precautionary switch from Europe to US equities has paid off, helping to lower the damage on the overall portfolio. However, the Emerging Market fund was unexpectedly hit as the swift sanctions imposed on Russia over the weekend forced the Russian government to close the Moscow Stock Exchange until further notice. As a result of the sanctions, fund houses are mandated to sell off their holdings to in order to comply, but as the same time, they are unable to do so due to a shuttered stock exchange. Hence fund houses are forced to write off their Russian stock holdings until the stock exchange is opened in order for them to price the value of their Russian stock. Our portfolio has a 0.8% exposure to Russian equities, and it is a loss that we are able to easily recover over time.

The cash portfolio lost 0.3% and the CPF-Is has lost 1.3% during the month of Feb. Since the start of March which marks the start of the Russian Ukraine war till the day of writing this post, the cash portfolio lost 0.86%, SRS lost 0.82% and the CPF-IS lost 2.08%. The damage is minimized due to our overweighted allocation to US equity and bonds which are seen as a safe haven in such an event.

As the shock of the war get priced into the global stock market, the attention of the main factor driving the stock market will be focused back on the US interest rates trend again. With concern of a slowing economy due to the war, the US central bank might slow down the rate of interest rate increase, which will be a positive for the stock market. 

I will expect that the market will remain very volatile in the coming days and I will keep monitoring the situation in Ukraine and may move a portion of our bond holdings into equity should the situation turn for better in the near future to take advantage of a potential relief market rally, after the recent correction as a result of a combination of inflation fears and shock from the war.