After several weeks of diplomatic tensions, over the last few days the word has watched in shock as Russia invades Ukraine. By way of background, the Ukraine was part of the former Soviet Union and gained independence from the USSR in 1991 following the gradual collapse of communism in central and eastern Europe in 1989. The recent tensions can be traced back to 1994 when the Budapest Memorandum was signed by the US, UK, Russia and the Ukraine when the Ukraine essentially agreed to give up their nuclear weapons and in return recognition of their sovereignty and ‘assurances’ of assistance should they face aggression. The west also opened the door for former Soviet states such as the Ukraine and Georgia to become members of NATO which was deemed to be unpalatable to the Russian government. Roll forward and we have seen Russian annex the Ukrainian region of Crimea in 2014 as well as making incursions into the eastern Ukrainian regions of Donetsk and Luhansk. The situation is complex and the coming days and weeks will provide us greater clarity on the direction tensions may take.

From a market perspective, we have seen markets price in the risk of a conflict with five-year credit default swaps blowing out for Russia and the Ukraine debt reflecting the additional risk for swapping out sovereign default risk. Equity markets are likely to be volatile until there is more clarity on the situation.

Russia & Ukraine 5yr Credit Default Swaps (bp)

Source: Capital Economics

Geopolitical risks are difficult to predict and even more difficult to manage for within a portfolio context. In recent years we have seen growing tensions between China and the US, North Korea agitate, and ongoing conflicts in the Middle East, such as the Syrian conflict. Typically, markets tend to react sharply and quickly to geopolitical events. If we look at how markets reacted during the Gulf War in the early 90s when Iraq invaded Kuwait, the S&P 500 feel sharply but also recovered quickly. The chart below shows the drawdown from previous peak in the market. While every conflict is different, markets like certainty and a clear direction. Until that time, expect markets to be volatile.

 S&P 500, Drawdown from previous peak (%)

Source: Capital Economics

As we see the Russia/Ukraine conflict escalate our expectation is that energy prices will increase given Russia is a large oil and gas producer and Europe relies heavily on Russian energy. A significant development has been the move to block Russian banks from the SWIFT global payments system and freeze the Bank of Russia’s reserves which are expected to severely restrict movement of capital from Russia. We also saw the decision by Germany to suspend the Nord Stream 2 gas pipeline project, a gas pipe connecting Russian gas to Germany. This is significant because Germany essentially shut down its nuclear power stations opting for gas via the new pipeline. It will be interesting to observe whether this will be a catalyst for Europe to rethink their energy sources to reduce their reliance on Russian gas.

We are monitoring the developments in the conflict and are assessing what our potential exposure is to Russia and Ukraine within the portfolios. Our portfolios remain diversified, and we hold assets such as gold and alternative assets within the portfolios which have been included to assist in managing risk. Coupled with this, we continue to assess the impact growing inflation may have on our portfolios having recently held interim investment committee meetings as new information comes to hand.

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