The Ukraine War through the Lens of an Investor

Owing to its geographical location, size, and multiethnic population, Ukraine has long been the center of various conflicts and struggles between world powers. After months of saber-rattling, ratcheting tensions, and questions about Russia’s intentions in Ukraine, the unimaginable has now become the inevitable: the largest military conflict in Europe since WWII, the Ukraine war. As the world watches gut-wrenching videos of the Ukrainian people facing impossible odds to bravely resist the Russian advance, many are wondering: how did we get here, where will the conflict go, and what will this mean for the global economy in general, and investors specifically?

Like many of our readers, we here at Crystal have been wondering how we arrived at an outbreak of war in Europe – a prospect many thought a relic of the past. To understand how we got here, it helps to understand a bit of Ukrainian history:

Sources:
National Geographic, February 2022. “Russia and Ukraine: the tangled history that connects – and divides – them”
Al Jazeera, February 2022. “Timeline: Ukraine’s turbulent history since independence in 1991”

Despite its independence in 1991, Ukraine has remained ethnically and politically close to Russia and the Kremlin. Today's war can be traced back to 2014 when a series of pro-Western and largely non-violent protests, commonly referred to as the Maidan Revolution, lead to a political realignment from East to West and the ensuing desire to join the European Union and NATO. As a result, Russia seized the southern region of Crimea, where Russia had long maintained a naval base in its provincial capital, Sevastopol. Near simultaneously, Vladimir Putin began a parallel movement to foment a pro-Russia insurrection in the Russian-speaking eastern region of Ukraine called the Donbas, made up of two provinces, Luhansk and Donestk.

While Russia had long maintained a dominant posture towards Ukraine, Russian aggression towards its neighbors has been happening since the breakup of the USSR with few consequences – since the establishment of the Russian Federation, Russia has stoked a series of low-intensity conflicts in rebellious regions of Moldova (Transnistria), Armenia/Azerbaijan (Artsakh), and Georgia (Abkhazia and South Ossetia), with Russia supplying troops, weapons, and materiel to these respective breakaway regions, and even Russian citizenship to the residents within them. Russia’s goal in these endeavors has been to maintain its influence over these former Soviet nations, often in response to their attempts at politically reorienting towards the West. In each of these breakaway statelets, Russia has been the largest of just a handful of countries that officially recognize them as sovereign states, despite nearly unanimous global opposition; and in 2008, Putin even launched a particularly brutal war against Georgia to preserve the existence of its rebel statelets.

In the face of these Russian aggressions, the West generally responded meekly, implicitly sending a message that the West would not be willing to make political and economic sacrifices, much less military ones, to protect the sovereignty of now independent states of the former Soviet Union. . It is in this environment that the Kremlin was emboldened to first recognize the Luhansk and Donetsk People’s Republics (LPR & DPR) as independent states on February 21st, 2022, and subsequently, begin a “peacekeeping mission” that has served as a pretext for the Ukraine war.

So, where will this nascent conflict go? Some experts believe Putin’s main goals in the Ukraine war are a decapitation, figuratively and literally, of the democratically elected Ukrainian government, establishing a new post-Soviet sphere of influence in Eastern Europe, a weakening of the NATO alliance, and the possible annexation of parts or even all of Ukraine. So far, it seems nothing has gone Putin’s way.

The Ukrainian forces have maintained unexpectedly fierce resistance to Russian advances. That said, Russia has also not yet unleashed the degree of terror against the civilian population, as seen in Syria, Georgia, and other conflicts around the world. The Kremlin has been held back by logistical issues as well - Putin initially seemed to expect that more Ukrainians would welcome the Russians and in turn that the military and government would fall in a matter of days, and as such, did not plan accordingly for a drawn-out campaign. At the same time, perhaps surprisingly in the face of the largest migration of refugees in Europe since WWII, with the UN expecting as many as five million refugees, tens of thousands of Ukrainians living abroad have actually returned home to fight, complemented by a newly created International Legion, with tens of thousands of foreign volunteers of its own aiding in the nation’s defense.

Equally detrimental to Russia has been the unprecedented unity of not just NATO and the West, but the world in general. Nations that in the past have maintained close diplomatic ties to Russia, from Hungary, Turkey, Kazakhstan, and China to a degree, have expressed outrage, and many countries have joined together to impose sanctions that we have typically only reserved for the most isolated of regimes – namely Iran, North Korea, and Venezuela. In turn, we have even seen a substantial number of large Western corporations withdrawing from or ceasing operations in Russia, with industries ranging from oil & gas to autos, to consumer goods, and even dating apps like Bumble. While the situation is ever-shifting, thus far the West has imposed personal sanctions on Kremlin-linked oligarchs and corporations, restricted airspace in the EU to Russian aircraft, blocked access to SWIFT (the primary interbank communication service that facilitates transactions for banks in 200 countries) for banks holding 80% of assets in Russia, and frozen the foreign reserves of the Bank of Russia, among other actions. Even famously neutral Switzerland, culturally committed to its financial openness to the world, is taking steps to block Russians’ access to funds. Already we are seeing the beginning of a financial crisis in Russia that is showing signs of being worse than the 1998 Russian financial crisis. The European Union has also committed to arming Ukraine, the first time in its history the Union has collectively financed weapons for another state.

From here though, it would be difficult to predict with any accuracy where the war can go. At this point, what Putin expected to be a rapid and relatively painless operation has become what will likely be a drawn-out conflict, pariah status for Russia and the Kremlin, and rumblings of internal public dissent by the Russian population. Thus, Ukraine and the world overall have pushed Putin into a corner, which could trigger him to take even more aggressive actions, both in Ukraine and in the wider European theater.

Whether it is just for show or with the potential of actually using them, Russia has activated their nuclear deterrent forces, which significantly escalates the potential for a nuclear miscalculation between Russia and the West. Moreover, Putin’s threats towards non-NATO countries expressing renewed interest in joining, like Sweden and Finland, as well as ominous statements he has made about the threat he sees from Eastern Bloc NATO countries like the Baltics and Albania, signal the potential for the conflict to grow beyond Ukraine’s borders. In the event of Russian victory, given its historical stoking of tensions in the breakaway Transnistria region of Moldova, a small nation with strong ties to both Russia and the West that borders Ukraine, he may have his eyes on conquering them next. Ultimately, there are many “unknown unknowns” here, with the consequences ranging from Ukrainian victory and Russian economic collapse to an all-out nuclear conflict.

First, some of the immediate outcomes, for now, have been the collapse of Russian assets, including the Ruble, and the Russian economy overall.

USD/RUB Data: YTD

Source: Yahoo Finance

MOEX Index Data: YTD

Source: Yahoo Finance

Already we are beginning to see the first signs of a bank run in Russia, with the Russian Central Bank responding by keeping equities markets closed and offering unlimited repo financing to the banks while accepting a much broader range of collateral. Russia’s industrial, agricultural, and energy industries, all dominant on the world stage, will likely face severe difficulties. The result of the weakening Russian economy and prospects for a wider war breaking out have also led to increased volatility in asset markets across the world, from industries ranging from energy to transport to cybersecurity and more, affecting nearly every marketplace across the world.

VIX Index Data: YTD

Source: Yahoo Finance

While volatility is always a concern for investors, the right multi-strategy hedge funds, which generally aim to engage in uncorrelated investment strategies, can possibly help investors alleviate some of the overall pain of erratic and unprecedented price action.

Additionally, the US and the EU are nearing an agreement to block Russian oil and gas imports.

Moreover, with industries like Western energy companies divesting of Russian natural resource investments, Russia and Ukraine’s supply of rare earth metals and other commodities that are essential to high tech manufacturing and computing, it is possible these industries will suffer in the wake of war and heavy sanctions. However, corporate risks from Russia are not limited to commodities-focused industries. Several major shipping companies have agreed to end shipments to Russia for everything excluding food, medicine, and other humanitarian goods. As a result, we may see increased supply chain bottlenecks and in turn more stubborn and persistent inflation. Industries ranging from luxury goods (Italy, France), autos (Germany), real estate (UK and EU) to European banks, and more, with high exposure to corporations and the upper-class citizens of Russia, face risks as well.

European Financials Pricing Data: YTD

Source: Yahoo Finance

It is in this environment that institutional global macro hedge funds have attracted investors, based in part on their ability to position their portfolios in the face of rapidly evolving geopolitical situations.

However, for US assets, we have already seen a divergence between various sectors, with the expected shift towards defensive stocks. As fears of Russian attacks on the West increase, both in the real and the virtual world, we are also seeing a boost to Aerospace & Defense as well as Cybersecurity stocks.

Aerospace & Defense Data: YTD

Source: Yahoo Finance

Moreover, although the US is already facing inflationary pressures that the Ukraine war is exacerbating, we may see some volatility in expectations for rate hikes from the Fed in response to the economic headwinds of reduced global trade and the prospect for war.

30-Day Fed Fund Futures Data: Dec 2022

Source: Yahoo Finance

Shortly after the invasion, December Fed Funds futures were implying a 30bps lower Fed Funds rate than they did at their high on Feb 10th, and while rates have reverted to their pre-invasion peaks, the economic effects of sanctions may metastasize to affect Western economies, particularly if a miscalculation between warring parties drags the U.S. and NATO into conflict with Russia. Were the West to engage in direct conflict with Russia, there’s a possibility that expectations for rates could soften. Lower rates may offer a boost to equity and debt assets, but we’re likely to see diverging results in both equity and bond markets – here, equity market neutral funds may help remove overall risks from stocks.

Overall, the world is faced with a lot of uncertainty about the future while Ukraine defends itself from Russia. While the prospect for a fiercer Ukraine war and an outbreak of global conflict are on the brink, some investors are concerned with how their leaders can protect Ukraine and the broader world from further war, and while it may seem trivial when compared to the death and destruction we are all witnessing on TV, they are also concerned, understandably so, with how they can protect their portfolios. In these environments, hedge fund strategies focused on uncorrelated returns and limiting volatility may help ease some of the overall market risks and serve as a useful tool to limit exposure to a collapse of the Russian and Ukrainian economies and potential knock-on effects to a myriad of asset classes. Nevertheless, we hold out hope for a quick end to the conflict and fear and worry of citizens across the world, and for the safety of Ukrainians, both refugees and those who have stayed in the country.

Sources:
The Guardian, February 2022. “What does Russian recognition of breakaway Ukraine territories mean?”
PBS, March 2022. “Russian invasion of Ukraine underscores Putin’s long-held goals”
Insider, March 2022. “Ukraine revealed secret battle plans left behind by Russian troops”
BBC, March 2022. “How many refugees have fled Ukraine and where are they going”
Foreign Policy, March 2022. “Ukraine’s Foreign Legion Is Ready for Battle”
BBC, March 2022. “Ukraine: What sanctions are being imposed on Russia”
The New York Times, February 2022. “Putin’s Case for War, Annotated”
NBC, February 2022. “Putin puts nuclear deterrent forces on ‘high alert’ amid spiraling tensions over Ukraine”
The Washington Post, March 2022. “Russia considers nationalizing western businesses that have closed over Ukraine invasion”
Forbes, March 2022. “Amazon, 3M, Skechers – Here Are The Companies Cutting Ties With Russia Over Ukraine Invasion”