Could Russia’s attack on Ukraine turn into a macroeconomic event?

On the latest edition of Market Week in Review, Chief Investment Strategist Erik Ristuben and Investment Strategy Analyst BeiChen Lin discussed the impact of international sanctions on the Russian economy and markets. They also chatted about the probability of the Russian invasion of Ukraine becoming a macroeconomic event, and discussed the removal of Russian equities from major index providers.

How are Western sanctions impacting Russia?

Ristuben said the sanctions imposed on Russia by Western leaders in response to the nation’s attack on Ukraine are unprecedented in scope, with the primary objective being to wreak havoc on the Russian economy. “In the past week alone, sanctions have been imposed on individuals in Russia - particularly the oligarchs that form President Vladimir Putin’s political base - as well as companies with high Russian government ownership,” he stated. In addition, the removal of some key Russian banks from the SWIFT communications network has made it very difficult for banks in Russia to do business outside of the country, Ristuben noted.

The U.S., Canada and Europe have also placed sanctions on Russia’s central bank, he said, including freezing assets held by the Bank of Russia in other countries. “Russia’s central bank had built up a $650 billion war chest - about half of which is outside of Russia - and now, the bank won’t be able to get these reserves back into the country to soften the blow of the sanctions,” Ristuben explained.

He remarked that so far, the sanctions are having predictable effects, with Russia’s stock market closed the entire week of 28 February and its local bond market also shuttered. In additions, securities that were trading as depository receipts outside of Russia - such as ADRs and GDRs - are no longer trading, Ristuben said.

“The idea with all of these sanctions is to extract a heavy toll on the Russian economy in order to incentivise Russia to stop its assault on Ukraine - and right now, I think they’re working as intended,” he stated.

Two key ways the Russian invasion could transform into a macroeconomic event

Ristuben said that Russia’s invasion of Ukraine - a humanitarian tragedy with terrible consequences for millions of individuals - is still a geopolitical event, but noted there’s a risk it could transform into a macroeconomic event. The Russian economy, he explained, is about 1/13^th the size of the U.S. economy.

“There are a few key channels of escalation that could turn this into a macroeconomic event - and the first would be a military escalation by Russia,” Ristuben observed. This could involve an attack on a NATO (North Atlantic Treaty Organisation) country by Russia, he stated, which would require a response by NATO members, as an attack on one member is considered an attack on all members. Ristuben said that while this scenario would have the highest impacts, it also has the lowest probability of occurring. “I wouldn’t stay up at night worrying over this one,” he remarked.

The use of cyberattacks by Russia is another example of how the current crisis could evolve into a macroeconomic event, Ristuben said. He noted that the U.S. and Western Europe are already experiencing an elevated level of cyberattacks from Russia. “The concern today is that Russia may step up these cyberattacks to target specific infrastructure in the West, which could potentially cause fairly significant impacts on economic growth rates around the world,” Ristuben explained, adding that right now, these attacks have been contained.

Markets appear to also be viewing the crisis as a geopolitical event so far, he said, noting that on March 4 at noon Pacific time, the S&P 500® Index stood slightly higher than it did on 23 February - the day before the Russian invasion began. By contrast, the STOXX® Europe 600 Index is down about 4% since then, Ristuben said, adding that this isn’t too surprising, given that Europe is closer to the crisis.

In fixed-income markets, U.S. government-bond yields are trading around 25 basis points lower than prior to the invasion, Ristuben said, attributing about half of this drop to uncertainties around the Russia-Ukraine crisis. “The other half of this decline can probably be chalked up to reduced market expectations of U.S. Federal Reserve (Fed) rate hikes this year,” he said. Ristuben explained that markets are now expecting a rate increase of 0.25% at the Fed’s March 15-16 meeting, versus earlier expectations for a 0.50% hike. In addition, markets are now projecting five rate hikes in 2022 instead of seven, he added.

Major index providers drop Russian equities

Ristuben wrapped up the segment with a look at recent steps taken by major index providers in response to Russia’s attack on Ukraine. He explained that MSCI, FTSE and STOXX have all deemed Russian and Belarusian equities as un-investable, and are removing them from their indices.

“As a result of all of this, at Russell Investments, we will be working to thoughtfully reduce our holdings in Russia when markets reopen and there is liquidity,” he concluded.

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Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.