Russia Vs Ukraine: How Markets Will Be Affected

As all eyes focus on Russia’s war with Ukraine, the knee-jerk reaction from investors has been to buy defense and oil stocks. But before we follow the herd we should be a bit more thoughtful and apply game theory to the situation as if we were sitting at the helm with Putin and forced to make decisions based on the interests of his people.

What Is Putin’s Goal?

The Russian military had virtually encircled Ukraine before bombs were dropped. On 3 sides, a robust military presence pressured Ukraine with a 150,000 strong army of troops.

On February 21, Vladimir Putin made a speech that effectively rejected Ukraine’s national sovereignty. He then directed Russian troops into two areas of Ukraine, Luhansk and Donetsk, declaring them independent republics. 

Within 72 hours, Russia had advanced its agenda by declaring a “special military action.” Around the globe, heads of state responded with condemnation that a so-called “peacekeeping” mission was in fact a military invasion.

The strategy is clear: take control of Kyiv, Ukraine’s capital city. Putin also has a clear focus on major cities, such as Kharkiv. If Putin is successful, he will unite the two nations: Ukraine and Russia. This would be the first time since the old Soviet Union collapsed that the countries would fall under control of one government. 

How Will Russian Invasion Affect Stock Markets? 

The initial sanctions directed by Presidents and Prime Ministers in response to Putin’s aggressions included actions against Russian sovereign debt, financial institutions, lawmakers, and oligarchs.

Russia suffered a big setback when Germany chose not to certify the Nord Stream 2 natural gas pipeline under the Baltic Sea that connected the two countries.

Since then the sanctions have expanded:

• The Biden administration announced sanctions against Russia’s central bank on Monday, a move that prohibits Americans from doing any business with the bank as well as freezes its assets within the United States.
• The new measures will also target the National Wealth Fund of the Russian Federation and the Ministry of Finance of the Russian Federation.

These measures will directly hurt Russia’s economy. Indeed the Ruble is free fall. Not since Long Term Capital Management blew up, and nearly took the world economy down with it, has the Ruble suffered such a fate.

While the conflict and sanctions are aimed at solely hurting Russia, the reality is an interconnected global economy has and will affect the US economy too. Indeed, the S&P 500 has already fallen by 10% from its most recent peak, which is the threshold required to officially hit correction territory.

Will Gas Prices Go Up?

The global connectivity of commerce is exemplified by Russia’s substantial exports of oil and gas, which respectively amount to 12% and 17% of world supply. A supply shock with similar demand will lead to higher prices – economics 101. Some estimates place the price per barrel at close to $120. In California, the gas prices at the pump are projected to rise as high as $10 per gallon.

The odds of the United States let alone Europe, who are heavily dependent on Russian oil and gas, placing restrictions or sanctions on energy exports is low. However, Russia may struggle to produce the oil and gas needed to furnish exports if its access to the global financial system is impeded, as is the case now.

The knock-on effect of higher energy prices will be higher prices for non-discretionary purchases like food and apparel. A dark spot on the horizon will be industries that are negatively correlated to oil prices, like airlines. As fuel prices surge, expect their profits to fall. 

Is it smart to short airlines? The longer the war, the smarter the bet will appear as the longer energy prices will remain elevated.

Which Stocks Will Go Up?

While airlines could suffer, other industries will benefit. Specifically, companies that are positively correlated to the price of oil: Schlumberger, Halliburton, and Occidental Petroleum to name a few.

For those who prefer a more diversified approach to betting on higher energy prices, the following ETFs are candidates:

• Energy Select SPDR Fund, the Vanguard Energy ETF,
• Invesco Dynamic Energy Exploration & Production ETF, 
• First Trust Natural Gas ETF. 

Which Stocks Have Russian Exposure?

As it turns out, the list of companies with direct exposure to Russia are fewer than you might imagine. McDonald’s, Pepsi, Philip Morris, and Boeing are a group however that are at risk.

As the fog of war blurs investors’ visions, these companies may suffer share price declines in the coming months. Those who have been around the block know that the time to sell, if you’re going to sell, is now, not later at lower prices.

Until the economic climate stabilizes, it’s best to be cautious. Only this week has the nuclear threat raised its head for the first time in decades. That should spark fear in all investors and catalyze a decision to act defensively first.

War & Stocks: What The Future Holds

Markets hate uncertainty, which explains why the stock market has churned as tensions between Russia and Ukraine escalated. History shows that after the initial decline, stocks have in fact rebounded well, even during war times.

The lesson is that the period leading up to war and the early stages of war sparks fear and market declines but thereafter normalized market pricing returns, and economic progress leads to a return to higher prices.

Even during war times, investors become familiar with the uncertainty of war, which causes market behavior to return to more normalcy. Short-term volatile, long-term bullish is the lesson from history.