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How The Ukraine Russia Conflict May Affect Your Investments

March 6th, 2014

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

"You dont just, in the 21st century, behave in 19th century fashion by invading another country on a completely trumped-up pretext" - John Kerry

Unless you've been hiding in a hole, you'll have by now heard of the Russian takeover of a Ukrainian region called Crimea. In this blog post, I'll talk about how the conflict may affect our financial health.

Impact On Russia

On the first trading day after Russia began to occupy Crimea, the Russian stock market fell by almost 11%, the most in 5 years. At the same time, the Russian currency (i.e. the ruble) also fell 1.4%, which is a lot for a currency, to the lowest point in 5 years.

Such sudden fall in currency values hurts the economy. If you're living in Russia, imports now cost more, which means that inflation has gone up overnight. Also, Russian companies that borrowed foreign currencies now have heavier debt burdens when measured in rubles. For example, a company that borrowed $1 million and exchanged it into 33 million rubles, now needs more than 36 million rubles to pay the loan back.

In order to stop the ruble from falling any further, the Russian central bank raised its interest rate from 5.5% to 7%. When you raise interest rates, you make holding money in rubles more attractive, because investors now earn 7% risk free in terms of rubles. However on the flip side, raising interest rates hurts the economy, because loans such as mortgages come with much higher interest rates, which discourages people from borrowing to purchase homes, cars, etc.

All told, some economists estimate that if Russia continued to escalate the situation, the Russian economy would take a hit in the order of 3% of GDP. This is roughly how much the U.S. suffered in the aftermath of the financial crisis in 2009. In other words, going down the path of war would take a heavy toll on the Russian economy.

The Cost of Military Conflict in 21st Century

This is why, as John Kerry stated, that a country shouldn't take the 19th century approach of using its military today. That's because unlike in the 19th century, the world economy is very much interconnected. In today's world, economic power reigns supreme.

In the 19th century, nations were largely self sufficient. Each country produced its own food and built their own houses using raw materials dug up from within their own borders. When a country doesn't depend on another country for food, products, etc, the country can go to war without suffering huge economic consequences.

But today, each country to some degree specializes in an industry. China specializes in manufacturing. Canada specializes in producing raw materials. The citizens of each country need every one of these products and services. But instead of producing everything from within their borders, they produce what they're best at producing, and then trade. For example, Canadians will give copper to China in exchange for smartphones.

If war was ever to erupt between two trading nations, both their respective economies will take a big hit. For example, if Canada went to war with China, Canada will face a shortage of smartphones, whereas China will face a shortage of copper.

Effect Of Possible Economic Sanctions

Like Canada, Russia specializes in exporting resources, especially oil and gas (Europe is especially dependent on Russia for natural gas). In exchange, Russia imports many goods and services from the rest of the world.

Even though the situation in Ukraine hasn't escalated to a full blown war, the U.S. and the EU has threatened Russia with the prospect of sanctions. Right now, the sanctions proposed would only hurt Russian officials and not the Russian economy, but if the situation escalates, we could very well see more meaningful economic sanctions. Such sanctions would hurt the Russian economy as if Russia actually went to war with the West. The West will buy less of Russian oil and gas, while Russia will import less goods and services from the rest of the world.

If such a scenario happened, we would see a few things. First, we will see higher oil prices because we'd have less Russian oil. Higher oil prices meant slower economic growth in the past, so we would expect stock markets around the world to fall. However, one saving grace is that oil companies' stocks would rise, and the Canadian economy might get a lift as it tries to fill some of the void left by Russia.

Second, natural gas prices in Europe will rise significantly. Because this will significantly hurt European manufacturing, Europe will hesitate to enforce sanctions against Russia that limits their gas import. But if Russia becomes more belligerent, they might follow through. In such a scenario, European stocks will fall more than others.

Third, if the situation in Ukraine escalates and it looks like war will erupt, bond prices will initially rise. U.S. treasuries still enjoy the status of safe haven when anything goes wrong in the world, so investors around the world will bid it up. We already saw this happen on Monday. However, I believe buying bonds will be a mistake, as history shows that inflation rises during war times. Such rise in inflation will eat away at the real yield that investors receive from holding bonds.

And lastly, of course, the Russian economy will go into a tail spin. But if you've invested along the lines of our portfolios, you wouldn't have much direct exposure to the Russian economy anyway.

All in all, continuing trouble in Ukraine will make for a volatile world, with stock and bond markets moving up and down more violently than they have in the past year. I personally don't see much cause for alarm for now, but if that changes, I'll let you know on this blog. If you'd like to receive updates, make sure to sign up for my newsletter below.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.