The Drums Of War Are Beating: Prepare Your Portfolio For An Escalation In Ukraine

by: Hebba Investments


Friday's escalation in the Ukrainian conflict leads us to believe that additional sanctions (and counter-sanctions) will begin as soon as Monday.

Gold and gold stocks stand to benefit from both Russian counter-sanctions aimed at the US Dollar and general financial market chaos that may result.

Platinum and Palladium ETFs and equities would benefit from the reduction in Russian supplies as they are the second largest global producer of both metals.

Fertilizer stocks stand to benefit as both Ukraine and Russia are major players in the global fertilizer market.

The crisis in Ukraine has been ratcheting up over the last few weeks after Russia annexed Crimea (or invaded it - depends on which side you take). There was some hope last week of de-escalation as the so-called Geneva was signed, but on Friday it became apparent to even the most fervent supporters of the agreement that it was clearly a non-factor as both sides have accused the other side of breaking the agreement.

It first started with an S&P downgrade of Russia:

In our view, the tense geopolitical situation between Russia and Ukraine could see additional significant outflows of both foreign and domestic capital from the Russian economy and hence further undermine already weakening growth prospects," S&P wrote in its report

Source: Wall Street Journal

This was then followed by a furious Russian response that accused S&P of making the downgrade for political reasons, and then Russia promised that any sanctions would be met with a retaliatory response that would strike hard at Western and European interests. Finally, Germany's Prime Minister Angela Merkel admitted that the Geneva Accord has failed and that the G-7 was discussing joint action against Russia. All the while, Russia was increasing its large troop buildup on the Ukrainian border and begun advanced military drills which included fighter jets.

We don't know what will happen here, but investors should prepare their portfolios for a ratcheting up of sanctions on Russia and the Kremlin's retaliatory response. We think we've passed the point of no return as the West cannot back down without looking extremely weak, and Russia believes that this conflict is about the existential survival of Russia itself.

We've seen sanctions applied to a number of countries in the past decade (Iran, Iraq, North Korea, Syria, etc.) without much of an impact to global markets, but in this case true sanctions that have a bite would have a much more profound effect on global markets. Russia is capable of powerful counter-sanctions (especially in regards to Europe), but more importantly has a military to insure that physical sanctions cannot be applied - all sanctions must be financial in nature. The problem is financial war begets financial war and that means stock markets and possibly the dollar system itself - if Russia is intent on causing financial chaos in the markets, then investors must watch out especially with what can at best be labeled a "weak recovery."

There are a few things that stand to benefit in the case of sanctions and retaliatory sanctions, and investors should consider them for their portfolios well in advance.

Gold and Gold Mining Stocks

Gold is an investor's best friend in times of financial chaos as thousands of years of human history can attest to, and we've never heard of a war that resulted in people selling their gold - it does best during wars (and government bonds perform the poorest). But in this current conflict gold may provide a much more idiosyncratic benefit as it is a direct beneficiary of any attack on the US Dollar.

Gold is first and foremost a currency, and at its core it is the ultimate reserve currency that has directly backed world currencies before our current dollar reserve currency standard was implemented in 1971. If Russia attempts to retaliate by attacking the US Dollar (as Kremlin aide Sergei Glazyev has mentioned previously), gold is the clear beneficiary as it is the only true alternative reserve currency.

Add in the fact that the gold market has nowhere near the capacity to absorb even a small transition of financial assets (as seen in the chart below), and you have the potential a significant jump in prices.

Source: FX Metals

Thus we believe that investors would be wise to maintain a strong exposure to gold with positions in physical gold and the gold ETF's (SPDR Gold Shares (NYSEARCA:GLD), PHYS, CEF). Investors looking for more leverage should consider gold miners such as Goldcorp (NYSE:GG), Agnico Eagle (NYSE:AEM), Newmont (NYSE:NEM), or even some of the explorers and silver miners such as First Majestic (NYSE:AG) and Pan American Silver (NASDAQ:PAAS).

Platinum Group Metals

The argument for gold ownership is related to financial chaos and its nature as the ultimate currency reserve. Platinum and palladium, while highly correlated to gold, stand to benefit more from the fact that any sanctions on Russia will probably involve their large platinum and palladium mining industries.

According to the USGS, Russia produced around 15% of the world's platinum (the second largest producer behind South Africa's 70%) and 40% of the world's palladium (tied with South Africa's 40%). Add in the fact that many South African mines have been producing at much lower levels (or have been completely shut down) due to worker strikes, and you have the formula for platinum group metal shortages.

Investors can take advantage of this by buying the platinum and palladium ETFs like the Sprott Physical Platinum and Palladium Trust (NYSEARCA:SPPP), ETFS Physical Platinum Shares (NYSEARCA:PPLT), or the ETFS Physical Palladium Shares (NYSEARCA:PALL). There aren't too many options for investing in platinum or palladium miners, but our favorite is Platinum Group Metals (NYSEMKT:PLG), as it provides investors with exposure to two large potential platinum and palladium projects in South Africa without the risk of mine shutdowns (they are development not production projects).

Fertilizer Stocks

Ukraine is a key nitrogen producing country, and is an important exporter in the global markets and accounts for around 8.5% of globally exported Urea and around 6.5% of globally traded ammonia. Sanctions and a potential military conflict in Ukraine have the potential to take much of this production offline and increase tightness in world fertilizer markets. Add in the fact that Russia is also a major player in the fertilizer markets, and it should be pretty obvious that increased Western sanctions would hit the fertilizer supply pretty hard.

Finally, it wouldn't be only the physical supplies that would be affected, but also the price of those physical supplies. Ukraine has been a price setter of a number of important fertilizer components since its production costs are significantly below other competitors, Russia's recent price increase of natural gas for Ukraine would raise their costs of production and would probably have an impact on world prices.

Major Western producers should see some nice benefits as their production would be unaffected by sanctions even as world prices increase, and their competitors would see both their supplies drop and costs of production increase. This would include companies like CF Industries (NYSE:CF), Potash Corporation (POT), and Intrepid Potash (NYSE:IPI) - it isn't surprising that all three of those companies saw an increase in their stock prices even as the market dropped on Friday.

Conclusion for Investors

The conflict in Ukraine has the potential of having a significant effect on the financial markets and investors would be wise to prepare, or at least hedge their portfolios, with companies and sectors that stand to benefit from a ratcheting up of the conflict. Investors should remember that this particular conflict has the potential to tremendously influence the markets in a matter of hours or minutes as the situation can turn on a dime. We cannot emphasize enough that Russia does have the power and the desire to create significant chaos in the financial markets if sanctions are increased to levels that truly bite. This is very different than the financial crisis of 2008 because of the fact that the world was unified in its attempt to minimize the negative consequences - this would involve players actively trying to hurt each other.

Add in the fact that indicators such as margin debt and investor sentiment have reached all-time highs of complacency, and wise investors would be best served in preparing for the potential of negative consequences for the financial markets - expect the best and prepare for the worst.

Disclosure: I am long SGOL, PLG, GOLD, PAAS, AG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.