Russian Roulette


  • The Russian invasion of Ukraine has caught most of us by surprise. The conflict seemed to follow a relatively predictable script. Russia pressed by building up military forces on the Ukrainian border to win concessions, while Western allies threatened with sanctions. But ultimately, a full-scale war was in no one’s interest.
  • Once the situation has escalated out of control, it is hard to discount this crisis as just one of the many geopolitical events that investors have to navigate. The Russian aggression has hit a wall of sanctions by the allies, who have turned out to be much more united, and more determined than expected. This leaves the nation with the largest stockpile of nuclear weapons, isolated and impoverished. The parallels with the Treaty of Versailles, and its dire consequences, are unfortunately unavoidable.
  • As investors, we have no choice but to accept that although this conflict may seem geographically contained, it has macroeconomic implications on a global scale. If energy prices remain elevated for a long period of time, consumers’ disposable income will decrease, and the Fed will struggle to fulfill its dual mandate of price stability and maximum employment. Hence the need to reposition portfolios in the face of the twin risks of higher inflation and lower economic growth.




Thursday, February 24 is a date that will sadly go down in history. That day, what had been looking like a calculated game of chess between all the parties involved in the Ukraine conflict turned into a geopolitical version of Russian roulette.


A full-scale invasion of the country clearly seemed to be in no one’s interest. This would entail the loss of human lives, the destruction of critical infrastructure and harsh sanctions that would harm both Russia and the countries that imposed them. But despite all the denials by the Russian authorities, it now seems clear that the decision to invade had been made long ago; and the phony efforts of Russian diplomacy were nothing more than a distraction in order to continue to accumulate troops, and try to divide the allies.


It is a very delicate matter to write about the financial and economic consequences of the conflict, when people in Ukraine are losing their lives and freedom. But the flip side of applying cold economic logic to such a dire situation is that this very rationale serves to highlight that wars are, at best, just a shortcut to short-term gains. Never a good long-term investment.


Almost all present borders have a violent past. In Medieval Times, the army was the most important industry in a country, and wars were the main gateway to increase wealth. Given that this was a sub-zero-sum game, it is not surprising that for many centuries the world economy stagnated. The Renaissance and the Enlightenment were necessary for a drastic increase in the standard of living to occur. There continued to be armed conflicts, but after World War II the world ended up internalizing that when progress depends on the free circulation of goods, capital, ideas and people, peace is a much more profitable enterprise.


Since then, deterrence and diplomacy have brought great economic growth, with the added benefit that large investments in military capabilities have resulted in civil use spillovers – Silicon Valley began as a sort of laboratory of the US Army, and the Cold War gave us the Internet and the GPS. Unfortunately, Russia’s invasion of Ukraine fundamentally disrupts the post-war order and takes us back in time.


Economic sanctions on Russia will harm all parties. It was as difficult to think that Russia would take the step of invading Ukraine as it was to believe that a consensus would be reached among the allies to kick Russia out of the SWIFT payment system (probably aiming to set a precedent for China in its dispute with Taiwan). With the sanctions announced to date, the Russian economy will undoubtedly take a big blow.


Even assuming that the country is allowed to continue exporting its abundant natural resources, severing its financial system from the rest of the world will at best severely limit its ability to attract capital, and at worst trigger a banking crisis. The ruble will inevitably depreciate, making imports more expensive and lowering the standard of living of Russian citizens. High inflation and negative growth will afflict the country; all this while it will have to continue diverting a large part of its GDP to defense investments, if, as it seems, its confrontation with the West will be long-lasting.


There will be some reciprocity in the economic pain, as the Western allies will also have to increase military spending, and will suffer from higher inflation due to the destabilization of energy markets. This is going to happen at a time when inflation is the number one problem for the world economy. High gasoline and electricity prices will dent on consumers’ disposable income and slow down consumption. It remains to be seen whether this will ultimately lead to a recession, or a short period of stagflation. The answer will probably depend on how the Fed reacts to the twin shock of higher inflation coupled with lower growth.


At a regional level, Europe has the most to lose due to its dependence on Russian gas. This will affect not only consumers but will also have a negative impact on industrial production. Asia, being also a net importer of oil and gas, will have to compete for scarcer resources in global markets. The US has the ability to increase shale oil production and will be better able to weather the shock; although the difference is that the kind of “consumption tax” that the rise in the price of crude oil entails, benefits domestic producers, and reverts to its own economy.


The divergent impact will also be reflected in the currencies of the respective economic blocks. With inflation differentials between the US and the rest narrowing, and rate hikes in Europe being indefinitely postponed, the dollar will remain strong.


The most plausible scenarios for financial markets range from a relatively short period of volatility like the one that followed the US invasion of Iraq (if the conflict de-escalates relatively quickly) or a prolonged period of high energy prices like the one experienced after the two oil crises (if the conflict ever affects Russian oil and gas supplies). Our base case remains that cool heads will eventually prevail. However, judging by President Putin reckless behavior so far, one cannot completely rule out that this crisis could take on a new dimension.


The most effective hedge against the combination of high inflation and low growth are assets that generate stable income and can adjust to rising prices. Stocks are one of the best alternatives, particularly if companies can pass on price increases to their customers. Cyclical companies are among the latter, but their revenues decline when the economy slows down. By contrast, Quality and Growth stocks tend to outperform in the latter environment and, given that their valuations have recently become cheaper, look like a safer bet today.


On the fixed income side, the risks at the moment are very binary. The safety offered by US Treasury bonds does not work in a stagflationary framework. But such an environment is usually unstable, and sooner or later it tends to end in a recession. Faced with such uncertainty, TIPS (inflation-linked bonds) emerge as an intermediate compromise between both scenarios.


The bill to be paid for this war will surely show that peace would have been a superior option. And even if the costs are shared among all parties involved, there is no doubt that the gap in prosperity between the liberal democracies and an increasingly authoritarian Russia will widen.


The two Koreas are a very good reminder of the opportunity cost of being on the wrong side of history. And the S&P 500 also offers a very telling story of the value that human ingenuity and entrepreneurship can create in conditions of freedom; notwithstanding all the conflicts experienced, including the Cold War that now seems to resurface.


The fundamental premise when evaluating geopolitical conflicts is to assume that there are “adults in the room”. Therefore, our take is that what has happened in Ukraine has been a serious strategic miscalculation by Vladimir Putin; but judging by his threatening demeanor, this is no longer a trivial assumption. As investors, we have reason to remain optimistic about the future of the free world, but as risk managers, we must recognize that we are witnessing a crisis of an unprecedented severity.



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