The horrors unfolding in Ukraine are deeply upsetting on every level. As investors, it is our job to separate emotions from facts that alter our 9–12-month view of the economy and financial markets. The situation in Ukraine has deteriorated at a rapid pace in recent weeks, challenging some of our earlier assumptions and raising the risk of a more substantial impairment to global growth—Europe, in particular. As a result, we have reduced our equity overweight, bringing our international developed equities exposure in line with our benchmark. Those proceeds have been added to cash. We retain a modest overweight to U.S. and emerging markets equities.
Twenty-four hours after Russia invaded Ukraine, Wilmington Trust held a client webinar outlining our portfolio positioning and two key assumptions necessary to avoid a material downgrade of global economic growth:
- No meaningful reduction in supply of oil or gas flowing from Russia
- The conflict would evolve in a way that would preserve the infrastructure of Ukraine and avoid a broader commodity supply shock
In the past few days, however, both of these assumptions have broken down, and we have adjusted portfolios as a result.
Over the weekend of February 26, the West united to unleash an unprecedented level of sanctions, including the removal of seven Russian banks from the SWIFT system (which provides services related to the execution of financial transactions and payments between banks worldwide) and sanctioning of the Russian Central Bank. These sanctions will cripple the Russian economy. Noticeably absent were any sanctions touching oil and gas companies or exports directly.
However, the risks of energy supply disruption are rising. Despite policymakers recognizing that restricting energy supply could be quite painful for consumers already reeling from the highest inflation in 40 years, the U.S. has announced a ban on Russian crude imports. So far, European allies are not on board. Russian oil made up 3% of U.S. crude imports in 2021, according to the U.S. Energy Information Association and Bloomberg. These headline risks contributed to oil’s biggest daily swing ever on Monday.
Russia has also threatened retaliation for recently enacted sanctions, which obviously could include shutting off their spigots. Even without overt sanctions on Russian energy exports, there are numerous indirect ways in which supply could be disrupted, including through lack of financing, refusal of shipping companies to accept Russian product, destruction of infrastructure, or “self-sanctioning” by companies and countries. BP took less than a week to decide to pull its 20% stake in Rosneft, the Russian gas goliath. Shell also moved quickly to cut ties with Rosneft. Although Western firms are still technically free to buy Russian output, there are reports of buyers balking, effectively reducing supply from Russia. So far, OPEC does not appear willing or able to add production, though they could step up in the event of an actual supply disruption. Clearly, their existing relationship with Russia and modest spare capacity makes that calculus tricky. A deal with Iran could potentially add as much as one million barrels per day over a matter of months—by far the most meaningful opportunity to offset supply coming offline—but even that “deal with the devil” looks to be at risk due to Russia’s involvement.
There are also increased risks to supply of the broader commodity complex. Our second assumption above posited that—one way or another—the conflict would be resolved over a relatively short timeframe and without complete destruction of Ukrainian infrastructure. Russia and Ukraine produce an outsized global share of many important commodities outside of energy, including wheat, iron, aluminum, palladium, and key semiconductor inputs like neon (Figure 1). With risks building that the war will be extended and with massive destruction to infrastructure, the impact on inflation and supply chains could be significant.
Please see important disclosures at the end of the article.