Update: Our position in Russian assets
- Conflict will continue but will likely be regionally limited.
- Volatility will pick up; an extended drawdown is unlikely.
- Our exposure to Russian assets is limited, we currently remain overweight equities.
It’s extremely unfortunate that the Russia-Ukraine conflict continues to escalate. As the situation continues to play out, it’s still full of uncertainty. Moscow has recognized the independence of separatist regions, Russian troops have mobilized and military strikes have begun. All while President Putin maintains that Russia will not occupy Ukraine. Beyond a wave of sanctions, the U.S. and its allies have committed to hold Russia accountable and will respond in a “united and decisive way.”
While there is only one person that has an idea of how the situation will actually play out – he resides in the Kremlin in Moscow, Russia – we can take the available information and position ourselves in a way that considers the different possible outcomes. Additionally, we will adjust our positioning as the situation changes and more information is made available.
Our current thinking: Conflict will continue but be limited
We have been closely monitoring the situation since tensions started to escalate last fall. Part of this was mapping out various paths the situation could evolve into, from détente, to all-out war. We recognize our ability to predict exactly what will happen is near-zero, so this multi-outcome framework allows us to evaluate these different scenarios on our portfolios as the situation evolves. This allows us to check that our portfolios are still suitably positioned, even under the worst-case scenario. Additionally, it allows us to evaluate potential opportunities and risks that might arise.
Unfortunately, recent events suggest we are moving in the direction of an all-out conflict between Russia and the Ukraine. The diplomatic resolution scenario is regrettably gone.
To be clear, we do not expect a Russian invasion beyond Ukraine. This would be a direct conflict with NATO forces and would result in an armed conflict between nuclear-powered nations. In this scenario, no one wins, least of all, Russia. President Putin himself has recognized that Russia does not have the strength to overwhelm NATO forces. Any talk of nuclear war to date has been framed to deter NATO from intervening in Ukraine. This will effectively allow Russia to overwhelm their much smaller neighbor in conventional warfare.
The question now becomes how far is Russia willing to go? Is it using a ‘shock and awe’ approach to demoralize Ukraine into conceding claims to Crimea and the separatist regions in Donbas? Or, does it want a regime change in Kyiv by installing a government aligned with the Kremlin as in Belarus? At this point, indicators suggest it’s the latter, but perhaps this could be posturing to maximize leverage.
Whatever Moscow’s intentions are, the costs to Russia will grow exponentially as the situation is drawn-out, particularly if civilian casualties rise significantly. This will come with increasingly severe international response, including the most punitive sanctions as well as the potential for persistent insurgency and conflict, draining Russian resources. As illustrated by the American campaigns in Iraq and Afghanistan, or even the Soviet Union’s own campaigns in Afghanistan, a more powerful military can relatively easily overrun a less powerful one, but the costs of continual occupation can be exorbitant. This supports the idea that Russia will be sensitive to civilian casualties and could be willing to de-escalate if it can secure its key objectives, but again, their exact objectives aren’t known.
Volatility yes, extended bear market unlikely
Geopolitical conflicts can lead to volatile global stock markets but typically do not lead to persistent drawdowns. History has shown that the initial shock can lead to stock price declines as some market participants sell into illiquid markets. But unless a recession follows where we see significant, sustained declines in growth potential and corporate earnings, these dips become opportunities to buy low.
For example, over the 20 years spanning the Vietnam war, the S&P 500 Index rose 150%, which, combined with dividends, resulted in an annualized total return of 8.1%.1 Similarly, during the 20 year period of the war in Afghanistan, the S&P 500 Index rose 261%, providing an 8.4% annualized total return including dividends.2 These returns are presented in U.S. dollar terms.
All this to say, military conflicts, even extended ones, do not break a solid, long-term investment case when conditions are supportive of economic growth and robust corporate earnings. It can certainly cause volatility, but as always, you’re better off focusing on what will drive global growth and corporate profitability, opposed to geopolitics.
Local markets will be more sensitive
Beyond broad global markets, local assets will be more affected by recent events. Specifically, Russian equities, bonds, the ruble and, to a lesser extent, European assets.
We have already seen deep discounts on Russian assets due to geopolitical risks. The MSCI Russia Index was trading at 5x forward earnings, 1x sales and 1x book value with a forward dividend yield of 11% prior to last night’s events.3 Ruble denominated bonds were trading at yields between 9.5% to 10.8% depending on the term.3 The ruble itself was trading at a significant discount to levels implied by Brent oil prices or the nearly 11% relative cash yield advantage built into forward contracts.3 Following the initiation of military strikes, we have seen a sharp selloff in Russian equities, a further widening of bond yields and a decline in the relative value of the ruble – making Russian assets even more heavily discounted.
Not to say that discounts aren’t warranted, but what we are seeing is normally associated with countries undergoing severe economic distress, which is clearly not the case. Russia has international reserves with a stated value of US$640 billion, a current account surplus of 5% of GDP (as of Q3 2021), a government that is currently running a fiscal surplus, a triple-B (investment grade) sovereign debt rating and a credible central bank which has pursued higher interest rates to control inflation.
Sanctions will pose a risk to Russia, but the most damaging sanctions to Russia, will be nearly as damaging to the countries that impose them, particularly the European ones. Many are reliant on Russian energy and commodities like metals and foodstuffs. In these early days, the initial wave of sanctions have stayed away from restricting Russia from participating in energy and financial markets.
We remain overweight equities overall, exposure to Russia is limited
Currently, we remain overweight equities relative to fixed income as we continue to see a low probability of recession over the next 12 months. Within our equity exposure, we continue to favour developed, North American equities, particularly U.S. equities, as growth and earnings will likely remain above potential. Additionally, U.S. equities are more insulated from the events in Europe.
With respect to Russian asset exposures, we are neutral emerging market equities as an asset class. We also have a modest exposure to emerging market bonds in our portfolios, which includes Russian debt.
Within the MDPIM Emerging Markets Equity Pool, we are overweight Russian equities. Prior to the most recent events, our exposure was approximately 7.5% – which is roughly 4% overweight relative to the MCSI Emerging Market Index. This position is focused on energy and materials companies that trade in physical goods. These positions are less at risk of international sanctions and earn significant cash flow given high commodity prices at this time. We have much less exposure to Russian financials, which are potentially more exposed to sanction-related risks.
In our foreign exchange strategies, we are long the Russian ruble as part of a basket of emerging market currencies, but these positions have been scaled at small sizes given the inherent risks.
We will continue to assess the situation as it develops and adjust our positioning if warranted. For more information, please do not hesitate to contact your MD Advisor*.
 Source: Bloomberg, for the period December 31, 1954 to December 31, 1975
 Source: Bloomberg, for the period December 29, 2001 to December 31, 2021
 Source: Bloomberg, as of February 17, 2022
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.