Should Wall Street Be Concerned About Ukraine?

|
Includes: RSX
by: Henry Ma, CFA

Summary

Ukraine crisis has limited impact on global financial markets so far.

Although the situation is still fluid, the crisis is unlikely to escalate into a full scale confrontation between Russia and the West.

Ukraine crisis is unlikely to derail the global financial market trends.

Last week, the Ukraine crisis was in the headlines again. G7 countries have approved a new round of sanctions against Russia. In addition to the current measures like asset freezing and visa bans against Russian high level officials, the sanctions may target individuals with influence in sectors of the Russian economy, such as energy and banking. With tensions high between Russia and the West, Russian equity markets and the Ruble tumbled after Standard and Poor's lowered Russian sovereign rating to BBB-. The Russian equity ETF RSX plummeted by 9.4%. On a year to date basis, RSX has tumbled by 25%.

However, outside Russia, global stocks seemed to ignore the Ukraine crisis for the most part. Since the beginning of 2014, the S&P 500 Index climbed by 1.1%, and the MSCI EAFE index rose 0.5%. The MSCI Emerging Market Index was down slightly by 2% (see graph below). Is it right for Wall Street to shrug off the Ukraine crisis? Our view is: Although the situation is still fluid, the conflict is unlikely to escalate into a full scale confrontation between Russia and the West. Thus, the impact on global financial markets is likely to be limited.

The causal link between geopolitical events and stock market performance is not so straightforward. Equity markets' performance in the end has a lot to do with the general economic conditions and earning prospects, which may be impacted by geopolitical events. The annexation of Crimea and the potential civil war in the south and eastern Ukraine so far have had very little impact on the global economy. Thus, it is possible for global stocks to continue performing well, even as the uncertainty in Ukraine continues. The most recent geopolitical events, such as the Arab Spring and the civil war in Syria, did not derail the global stock market trends.

One potential risk for the global economy, especially the European economy, is the disruption of energy supply from Russia. According to the Energy Information Administration (EIA), Europe consumed 18.7 trillion cubic feet (TCF) of natural gas in 2013. Russia supplied 30% of this volume, with 16% of the total natural gas consumed in Europe passed through Ukraine's pipeline network. The natural gas price jumped 25% in 2014 because of the fear of disruption in Ukraine and the cold weather in the US (see the graph above). Of course, high energy prices could have some significant negative implications for the global economy.

As the tensions between Russia and the West escalate, some analysts have pointed out that Russia may decide to halt the gas flows through Ukraine as a counter-sanction measure. We believe that this is an unlikely scenario unless a full-scale confrontation develops. Although Europe depends on Russia's energy, Russia depends heavily on the energy revenue from the West. European consumers pay about US$100 million a day to Russian coffers, accounting for about 3% of the country's gross economic output. The revenue will be hard for Putin to ignore.

Two other factors may favor Europe in the short term if Russia decides to halt the gas flows. First, the mild European winter has allowed countries to build sizable reserves that could last months. Second, Europe has some other alternatives for natural gas, such as Algeria and Norway for increased imports, as well as additional pipelines from Russia that flow north of Ukraine and the trouble zone.

We are not suggesting that Europe would not suffer if Russian imports were halted or delayed in any way. For a fragile European economy, which is just out of debt crisis and recession, an energy disruption and price hit could prove disastrous. However, we think the probability of halting gas exports to Europe by Russia is fairly low. It is a lose-lose situation every party wants to avoid.

Disclosure: I am long RSX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.