Here, our investment specialist Philip Bailey takes a look at the developing situation in Ukraine and considers whether this should influence investment strategy.

It’s an exogenous risk, stupid

There are those that suggest the primary risk to the capital markets is geopolitical. I don’t agree (1).

There are lots of risks, you can list different risks until the cows come home. Some of them are comparatively easy to mitigate through proper diversification (2). Some of them are less easy to mitigate.

Geopolitical risks, brought on by wars and civil wars, are in the ‘less easy bracket’ but we do have one saving grace. Different market participants react differently to these events – some see them as an opportunity to invest while others see them as a cause to sell. The diverging views of investors help to smooth the effect of such shocks on asset prices.

It’s not easy to see this smoothing process in action but consider the following:

War and asset prices

Ours is a world in conflict. Last year, there were no fewer than 33 wars (3) ongoing. Indeed, very recently, the United Kingdom was a belligerent in two large-scale conflicts. But none of those precipitated a stock market crash. The last 20 years have not been characterised by peace and prosperity, but war (or the prospect of war) does not feature in a list of woes that are generally considered to be influential in shaping asset prices over that period (4).

A dangerous place

I am not suggesting that we should disregard geopolitical risks. We shouldn’t. And I have to admit that enmity in east Ukraine does concern me. But recent conflicts, at least, have had a limited impact on asset prices in the developed markets. And with that in mind, let’s take a look at the trouble in Ukraine.

Russia is a vast country but it is not densely populated. Lacking the protection offered by natural borders (great rivers, imposing mountain ranges) she has, in the past, proved vulnerable to attack on her western flank in particular. Against this backdrop, Russia has been keen to maintain some kind of buffer in front of those borders. As a consequence, we have seen fierce Russian opposition to movements within former Soviet states toward closer ties with the West. In fact, Russia has established a very particular pattern of behaviour in dealing with this threat.

Six years ago, not long after Georgia made clear its intentions to join NATO (5) , Russian troops were sent into Georgia’s South Ossetia and Abkhazia regions. The deployment of troops was preceded by support for ethnic Russian political groups in the first instance and informal security forces or militias in the second instance.

The same pattern emerged in February this year and it culminated in the forcible annexation of Ukraine’s Crimean Peninsula. The trigger, this time round, was the collapse of pro-Russian Viktor Yanukovich’s presidency and the subsequent potential for closer ties between Ukraine and the European Union.

In east Ukraine, we have already seen Russian support for allied political groups and militia. That could ultimately lead to Russian troops landing in Donetsk or to Luhansk.

Your guess is as good as mine

Will Russia ever actually deploy troops? It certainly would not surprise me, but if they did, a Russian victory would be secured only with heavy losses (if not at first, certainly with time). Setting aside the military factors, other forces are ranged against Russia.

Flight MH17

First, the downing of Malaysian Airlines flight MH17 has altered the dynamic. Ostensibly, Russian troops were deployed in Georgia and in Crimea on humanitarian grounds. If, as seems likely, Russian-backed separatists brought down MH17 with a Russian-supplied surface-to-air missile, the humanitarian cloak is shed. As a result, the EU and the United States are fused in much stronger opposition.

The Russian bear market

Second, the MSCI Russia Index stands at around half its level in 2008 (6) when the Georgian invasion was launched.

Russia’s economy is sliding into a painful recession. Core inflation has accelerated to 7.5% and the Central Bank has been forced to hike rates from 5.5% to 8.0%. Business and consumer confidence is shattered. Capital is flying out of Russia at a rapid pace; around $76 billion in the first half of this year compared with $63 billion for the whole of 2013. Over the same period Russian banks have seen net withdrawals of almost $17 billion and Foreign Direct Investment has halved.

An escalation of the current conflict will see each of those factors deteriorate rapidly and I reckon that a dire economy is as dangerous to the tenure of Russian leaders as it is to those in the West (7).

Tougher sanctions will hit them and us, but mostly them

Clearly, this is not a conflict without economic consequence.

In the last few days, the European Union has strengthened its package of sanctions to encourage Russia to drop its support for the separatists. The new sanctions – what the EU call ‘tier three’ sanctions – include:

– A prohibition on Russian banks from buying or selling debt (with a maturity greater than 90 days) and equity in the EU
– An embargo on new arms sales and so-called ‘duel use technology’ that might have military applications
– A ban on exports of certain energy-related equipment and technology from the EU to Russia

These, combined with earlier sanctions, are likely to hit the Russian economy hard.

In the medium term, there will probably be knock-on effects in Germany, the UK and US too but at this stage I suspect that EU and US officials have managed to put together a strong package which limits the potential for self-harm.

So, what is to be done?

I think the conflict will remain confined (8). In short then, do nothing, though my usual caveat applies:

Make sure that investors hold risky assets only in the proportions that they would be comfortable to hold for the duration of a significant downturn. They shouldn’t be holding risky assets in the hope that they’re not going to be risky while they hold them.

If you’d like to discuss our thoughts on investment strategies Philip Bailey a call on 01462 687337 or email Philip at

(1) It’s one of a series of risks, but it’s not the primary risk. I’d say that the confluence of changing central bank policy and high valuations is the primary risk.
(2) Proper diversification, I’m not talking here about just putting your eggs in more than one basket.
(3) Source: Uppsala Conflict Data Program, compiled by the Department of Peace and Conflict Research at Sweden’s Uppsala University.
(4) Including the Asian currency crisis, Russian default, LTCM, tech bubble, the credit crunch.
(5) Georgia is not yet a NATO member, remaining an ‘aspirant partner’ (probably for some time to come).
(6) Down 47%. Compare that with the MSCI Emerging Market Index which has recovered all the ground it lost and currently sits 15% higher than the May 2008 peak.
(7) Though the mechanism for change differs. Of course, we could see somebody ‘worse’ rise to power in Vladimir Putin’s stead.
(8) The antagonists being the separatists with indirect and, perhaps, direct assistance from Russia on the one hand and Ukraine with indirect Western assistance on the other.