Financial markets in risk-off mode after Russia invades Ukraine

Despite the diplomacy of the last few weeks between Russia and the West, the war in Ukraine had already escalated earlier this week, when Russia declared the independence of the Donetsk and Luhansk regions in east Ukraine. In response, the West imposed sanctions against Russia. Today, the war escalated further with the invasion of Ukraine. Russia says it does not want to invade the whole of Ukraine, but the Russian army has also entered Ukraine from the north at Ukraine’s border with Belarus.

Russia has said that its goal is to demilitarise Ukraine and replace its government. But it is unclear if it will attack the capital of Kyiv and if it will indeed invade the whole of Ukraine. Western leaders and members of the UN security council denounced the attack. The West has already announced that more severe sanctions against Russia will follow. The severity of these sanctions and Russia’s response will be an indication of how the situation will evolve.

Investors, in general, prefer to avoid uncertainty, but this is exactly what a geopolitical or military conflict brings. Looking at history and earlier military conflicts, it is typical that equity markets initially decline, and this can last a couple of days or, even, weeks. But, equity markets usually also recover quickly once clarity emerges regarding the development of the conflict. When this occurs, focus can return to underlying market fundamentals.

For now, we expect the macroeconomic impact of Russia’s actions to be mainly on the energy front via higher energy prices (oil and gas). Europe is more sensitive to this than other regions, as Russia is a large energy supplier to the continent and substitutions are limited. Russia is also a major supplier of other commodities, but their economic impact will be much smaller compared to oil and gas.

Due to the Ukraine crisis, the chance of a potential decline in investor confidence and the possibility of stagflation or, even, a recession scenario in Europe, are increasing, especially if the war endures for longer than expected. The impact on the rest of the world, however, could be largely limited. Over the upcoming weeks, it will be important to see how central banks react to the news and whether there is any change in their economic outlooks.

The economies of Russia and Ukraine are relatively small within the world economy. Their decline will have a very limited impact on global growth. However, higher energy prices can hit producers and consumers more widely. Luckily, the balance sheets of companies and consumers are relatively strong, due to the stimulus measures taken to offset the corona pandemic and lockdowns.

First of all it is important for investors to remain calm. Last week, the investment committee of ABN AMRO decided to reduce their equity position to neutral, take a more defensive sector allocation and retain their underweight in bonds. We also chose to remain overweight in the materials, financials and healthcare sectors. We are also monitoring our portfolio holdings closely in terms of exposures to Ukraine or Russia. Our decisions last week were mainly driven by high inflation and tighter monetary policies to come. Although we were monitoring the Ukraine war, we did not expect such a quick escalation.

For now, we suggest to not make any changes to your portfolio. There is too much that is still unknown, and it is usually not profitable to act hastily in volatile markets. History also shows that once a war recedes, financial markets can recover quickly. We will continue to monitor the situation and take action if needed. As a final note, our thoughts go out to the people of Ukraine.

Reinhard Pfingsten
Global Head Asset Allocation team and member of the ABN AMRO Investment Committee