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It’s been a little over a week since the unprovoked attack by Russia on Ukraine has triggered a war in Europe unseen since World War II. A humanitarian tragedy is unfolding before our eyes as Russia continues to attack civilian areas, the Ukrainian military continues to defend their territory, and over a million Ukrainian refugees have been forced to flee their homes.
This article isn’t about the war itself. There are lots and lots of people far more qualified than me writing about the day-to-day news in the conflict. We aren’t a news site, we’re a finance blog, so what we’re going to talk about is how this war has affected, and will continue to affect, the financial markets.
That being said, please know that in no way am I trying to minimize the suffering of the innocent people caught up in this. I am only covering the financial aspect of this tragedy because the other angles of this event are covered so well by the news already. Let’s hope that this conflict comes to a halt as quickly as possible, because this war is hurting everybody.
Should Russia Be Expelled From Our Investments?
The most immediate effect of the Ukraine conflict is that volatility has returned to the stock market. Stocks hate uncertainty, and a war in Europe involving a nuclear power is about as uncertain as you can get, so stock markets will be heaving up and down for the near term as the world digests this extremely unpleasant piece of news.
Obviously, stock market volatility is nothing compared to what Ukrainians are experiencing right now as their homes and livelihoods are destroyed by the advancing Russian army. However, it should be noted that the economic shock wave of the war isn’t limited to Ukraine. Russia’s economy is being absolutely hammered as well.
Punishing Western sanctions have cut off Russia’s banking system from the rest of the world, and the knock-on effects of those sanctions has been to trigger an almost immediate recession inside Russia. The ruble has dropped 40% since the war began, the Russian central bank has more than doubled their benchmark interest rate overnight from 9.5% to 20%, and unemployment has spiked as pretty much every country in the Western world refuses to do business with a regime that would attack a neighbour so viciously and without provocation. Just yesterday, VISA and Mastercard announced they were pulling out of Russia, instantly turning Russia into a financial black hole.
Visa said in a statement that it would cut off transactions “over the coming days” and consequently cards issued in Russia would not work abroad as well as foreign issued cards in Russia.Visa and Mastercard will both suspend operations in Russia, TheGuardian
Russian citizens have begun pulling their money out of their banks en masse as they rush to convert their savings out of rubles in a scene reminiscent of the hyper-inflationary environment of 1930’s Germany.
With all that happening, you might be tempted to think that a Russian recession’s impact on a globally diversified portfolio would be pretty catastrophic.
You would be wrong.
Despite Russia’s size and military strength, on a global scale the economy of Russia is surprisingly small. Russia’s 2020 GDP of $1.48 trillion may seem like a large number, but Canada’s is higher at $1.64 trillion. That’s right, somehow Canada’s economy is technically bigger than Russia, despite them having nearly 4x the number of people (144 million versus Canada’s 38 million).
Russia’s participation in the world stock market is also surprisingly small considering how freaking huge the country is. In the MSCI Emerging Markets Index represented by ticker symbols XEC (CAD-denominated) and IEMG (USD-denominated), Russia represented only 2% of the shares being traded. That’s not 2% of the world economy, that’s 2% of an index specifically designed to track emerging markets.
And now, they won’t even have that as MSCI has announced that they have removed Russia from the index completely.
Russia’s stock market is “uninvestable” after stringent new Western sanctions and central bank curbs on trading, making a removal of Russian listings from indexes a “natural next step”, a top executive at equity index provider MSCI said on Monday.MSCI says removing Russia from indexes ‘natural next step’, Reuters Business
Note that this announcement is not for a move that will take place sometime in the indeterminate future. They’ve already pulled the trigger. Russia is no longer listed under the geographic breakdown of their ETFs.
So if you were wondering whether our Investment Workshop portfolio had any Russian exposure, the answer is: They used to, but not anymore.
Bye bye Russian companies. You will not be missed.
Interest Rate Outlook
The other potentially major impact of the Ukraine conflict on the financial world is on interest rates.
Normally, when something like this happens central banks respond by dropping interest rates in order to stimulate the economy. They did it during 9/11, the Great Financial Crisis of 2008/2009, and of course the recent pandemic.
This time is different.
First of all, interest rates are already at rock bottom. You can’t go drop interest rates when they’re already at near-zero.
Second of all, because Russia is a major oil-producing country and outrage over their behaviour is prompting countries to block Russia from the oil markets, oil has increased in price. Already, oil prices as measured by the WTI crude benchmark has soared from $90 a barrel to $115. Prices at the pump have already responded, and consumers are likely going to see higher energy costs for some time.
All this means more inflation.
In a world still recovering from the trauma of the pandemic, and with inflation already sitting at levels that we haven’t seen in decades, this is the last thing consumers needed.
Taming inflation is central banks’ number one goal. And that means that they will have no choice but to keep raising interest rates.
In Canada, our central bank has already started.
The Bank of Canada announced Thursday that it was raising its key overnight lending rate by a quarter of a percentage point to 0.5 per cent, as it attempts to fight inflation driven higher by everything from energy prices to supply chain woes caused by the COVID-19 pandemic.Bank of Canada raises overnight rate to 0.5% — first hike in years will be the first of many, experts predict, Toronto Star
In a major decision that promptly got buried underneath all the news coming out of Europe, our central bank went ahead with their long-planned rate hike. They hedged the decision by saying that the uncertainty around Ukraine may change their outlook, but the reality is that they were backed into a corner.
Now all eyes are on the US Fed, which will make their move in the middle of March. Anything could happen between now and then, but odds are that they will follow suit and choose to tackle inflation rather than stimulate the economy.
Stay Globally Diversified
All this proves the importance of maintaining a geographically diversified portfolio. Betting hard on any one country or region opens you up to an unforeseeable geopolitical event like this from completely derailing your portfolio. But if you place your bets on multiple geographic regions, negative events like this in one region of the world can be counterbalanced by positive developments in other regions.
Check this out. This is the graph of the MSCI EAFE index. EAFE covers Europe, Australia, and the Far East, so it’s the ETF that we own that’s most exposed to this war. This is its chart from Feb 23 to today.
You can see the sharp drop on Feb 24, when the invasion began. Then a few days of optimism as the West began to impose sanctions, then a sharp drop afterwards as the war doesn’t look like it’s getting resolved anytime soon.
Now let’s look at the same chart with the US index as tracked by VTI overlaid on top. VTI is purple (because USA = Red + White + Blue = Purple)
The US index also experienced the same drop on the day of the invasion, but then recovered its losses as traders realized that this was, as of now anyway, unlikely to expand into a global war that might drag the US into it. The bet is that the US economy continuing to recover from COVID will have a greater impact than a war in Eastern Europe.
Now here’s where it really gets interesting. Here’s the same chart, but with Canada’s stock market tracked by the ETF VCN, in red.
That’s right. Canada’s stock market actually went up.
Why? Canada and Russia’s stock market share one thing in common: they’re both heavily commodities based. Specifically oil. They pump a lot of oil out of Siberia, and we pump a lot of oil out of Alberta.
Typically, when oil prices go up, our respective stock markets also go up. Higher oil prices mean higher corporate profits. However, with this current market shock, Russia’s going to have a lot of trouble going forward selling their oil to the world. But the world still needs oil, so they’re going to look to other countries to get it. Countries like…Canada.
And as a result of these counter-balancing forces, when I bring up my portfolio on Passiv for the same time period, this is what it looks like.
We are down slightly, but only by 1.2%.
Did I see this coming? That a Russian invasion would trigger global sanctions that drive oil prices up and made the Canadian stock market rally? No, no I did not. Not even close.
But that’s the power of geographic diversification. Negative events in one part of the world were counter-balanced by positive events in another. If you didn’t watch the news and looked only at this graph, you’d think nothing was happening.
So as a result, FIRECracker and I are planning to continue our 90% equity/10% fixed income. As we wrote at the beginning of the year, the math behind our projected living expenses this year ($43,000) and our portfolio’s yield ($44,000) tells us that we are no longer vulnerable to our portfolio’s day-to-day gyrations. We will keep our even split between Canada, the US, and EAFE because no matter what happens in the news, we will be able to keep financing our retirement with the dividends while still positioning ourselves to benefit long term.
Update on Johnny FD
Before we wrap things up, I thought I’d provide an update on our friend Johnny FD. The last time we wrote about him, the war in Ukraine had just broken out and he was stuck in Kyiv.
Since then, I’m happy to report that he managed to make it out safely. Apparently, him and another Youtube personality named Benjamin linked up and the two of them were able to escape Kyiv together on one of the last trains out of the city. Their journey was absolutely harrowing, but in the end they both made it out alive.
That being said, if there’s one tiny silver lining in this whole horrible affair, they filmed their escape and in my humble opinion produced one of the finest examples of citizen journalist I’ve ever seen.
To support the Ukrainian people affected by this terrible crisis, please consider donating to the International Committee of the Red Cross, or whatever reputable charity you prefer. Slava Ukraini! Glory to Ukraine!
Stay safe and stay invested, everyone.
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