Are we in the midst of a new cold war era?
Written and accurate as at: Mar 02, 2022 Current Stats & Facts
After several weeks of diplomatic tensions, the world has watched in shock over the last few days as Russia invades Ukraine. 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 Ukraine when 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 unpalatable by the Russian government. Roll forward, and we have seen Russian annex the Ukrainian region of Crimea in 2014 and make incursions into the eastern Ukrainian regions of Donetsk and Luhansk. The situation is complex, and the coming days and weeks will provide greater clarity on the direction tensions may take.
From a market perspective, we have seen markets price 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 more clarity on the situation.
Russia & Ukraine 5yr Credit Default Swaps (bp)
Source: Capital Economics
Geopolitical risks are difficult to predict and even more challenging to manage. 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 responded during the Gulf War in the early 90s when Iraq invaded Kuwait, the S&P 500 fell sharply but recovered quickly. The chart below shows the Drawdown from the 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 the previous peak (%)
Source: Capital Economics
As we see, the Russia/Ukraine conflict escalate expectations 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 Russia's movement of capital. 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 catalyst Europe to rethink its energy sources to reduce its reliance on Russian gas.
The uncertainty of this conflict and its impact on financial markets reiterates the importance of diversification. Diversification, or spreading your risk, is a key risk management strategy used when constructing a portfolio. It's the strategy commonly referred to as "not putting all your eggs in one basket". The premise behind diversification is that no one asset or type of asset performs the same. Shares, property, bonds, amongst others all tend to rise and fall at different times depending on economic, political and market factors. Effective diversification also includes holding an allocation to cash. Not only does cash help preserve capital, provide liquidity and offer a source for income, but it also enables the option to buy quality assets while they are distressed.