How worried should investors be about the Russia-Ukraine conflict?

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we consider whether a rise in Russia-Ukraine conflict tensions could rattle investors for longer or remain a transitory factor.

 

Need to know Markets have turned bearish in response to rising fears linked to the Ukrainian crisis. Up until 2020, the Ukraine crisis was an idiosyncratic risk. Today it seems to be interpreted as a systemic market risk. However, historically, geopolitical shocks’ negative impact on risk premia tends to be temporary. Retail investors left the market mid-January on the back of monetary policy adjustments while institutional investors stayed the course.

 

“A bear market is coming” is what many news outlets are proclaiming this week. After a messy mix of information warfare, energy markets and geopolitical tensions, Russia invading the largest country in Europe is the latest worry to land on investors plate. Is this bearish sentiment justified or is this just another transient scare? Let’s take a step back from the current escalation in war rhetoric to understand that.

 

Retail versus institutional investor

Since the beginning of the year, markets experienced drawdowns driven by monetary policy adjustments fears. This caused the vast majority of retail investors to jump ship as illustrated in Chart 1 (the AAII Bull/Bear survey, a typical gauge for retail market engagement) where today’s levels are comparable to 2008 and 2020. However, institutional investors stayed the course as shown in the second graph of Chart 1 (HFR Global Macro index’s beta for various equity indices, a proxy for institutional market engagement). From the end of January, glimpses of relief surfaced only to be brought back down by the fears associated with the Russian conflict on February 14th. 

Consequently, even though institutional investors’ equity positioning is still in positive territory, the exposure has been losing some steam. This sentiment of fatigue is noticeable across markets: rates declining, yen increasing and equities decreasing, and the VIX’s term structure sloping down now. This is the most bearish the market has gotten since the beginning of the year, but the actual losses are nowhere near crisis levels seen in 2008 and2020. Geopolitical risks lack clear predictable fundamentals and weigh hard on investors’ nerves. This points towards temporary and conventional market turmoil rather than the catastrophic “we are on the brink of WWIII” scenario.

 

Chart 1. AAII Bull – Bear Survey & HFR Global Macro Index’s beta for various equity 

 

Source: Bloomberg, LOIM. Note on the HFR Index: each data point represents the past 20 weeks.

 

Market lessons from past Ukraine crises

In the past, Ukrainian events remained a very idiosyncratic risk compared to typical systemic risk aversion episodes as illustrated on Chart 2. The Sharpe ratios of the different asset classes during the Crimea Invasion (February 2014), the pro-Russian protests (September 2014), and the Donetsk fighting (February 2015) are far from resembling those seen during events such as Brexit, the North Korean crisis, or the Trump election. What is barely noticeable during these Ukrainian conflict periods is the negative Sharpe ratio for emerging markets and the positive Sharpe ratio for energy. Therefore, historically, Ukraine remained a local issue rather than a global one. Is this still the case today?

 

Chart 2. Asset class Sharpe ratios in different market conditions

Source: Bloomberg, LOIM

 

What’s different this time?

Given the strong bearish sentiment, the Ukrainian crisis seems to now be interpreted by the market as a systemic risk. What used to look like an idiosyncratic risk event (left side of the chart) now looks a lot like proper risk aversion episodes: equities drop accompanied by increased volatility (while still rather contained lately), bond yields decline but gold rises and the VIX term structure slopes down. However, it is important to remember that geopolitical systemic risk events such as Brexit, the North Korean crisis, or the Trump election were all short-lived. They are risk aversion episodes not full seasons. A long-term bear market is usually not triggered by geopolitical unrest. It is therefore likely, in our opinion, that this correction is temporary. Granted, the risks of escalating to a world war have increased compared to the beginning of the year, but it remains a tail event that all parties are much better off avoiding.

 

Simply put, the current market stress and focus on geopolitical tensions should probably be transitory, shifting attention back to solid macroeconomic fundamentals.

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