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MD Financial Management: Chief Investment Officer Message—Our View Of The Impact On Financial Markets Of Developments In Ukraine

The current political uncertainty in Ukraine has caused some disruption in normal market activity but has had only a small direct impact on our client portfolios. Within our portfolio structures we have—for a portfolio with a 10-year time horizon—direct investments in international equities of 9% of which direct investment in Russia and Ukraine makes up 0.76%. At the portfolio level, this allocation translates to direct investment of 0.07% in Russia and Ukraine.

In short, we believe that the portfolios are well-constructed to withstand the effects of the current geopolitical uncertainty; however, there are nevertheless potential residual effects on our portfolios. These include investments in energy-related companies and the potential impact on gold prices. These positions are held within the context of a diversified portfolio structure that is constructed to manage, but not eliminate, volatility in asset prices over time.

At MD, our intent is to seek opportunities around the globe—and to manage both return and risk appropriately, through intelligent manager selection and a rigorous diversification methodology. Our investment process allows for prudent allocation of investment assets to areas where sometimes the risk of uncertainty is higher, in order to look to achieve higher investment returns. In the case of the situation in Ukraine, as in other, similar situations; we do not seek to avoid uncertainty, but we make decisions keeping our clients’ interests foremost.

Background: Recent developments in Ukraine

On March 1, the Russian parliament approved military deployment to the Crimea region of Ukraine. This development came after the ousting of Ukraine’s pro-Russia president Viktor Yanukovych by the opposition-controlled Ukrainian parliament in February, following months of anti-government protests in Ukraine’s capital city of Kyiv.

In our view, the swiftly-moving situation in Ukraine may have a two-pronged impact on investors and financial markets arising from both the looming risk of war in the region and, as a distinct issue, the developing financial risk in Ukraine.

Impacts for investors and markets: Two areas of focus

First, the potential risk of increased military involvement by Russia in Ukraine could depress growth expectations across the region, and dampen investor sentiment more widely across global investment assets that are highly sensitive to geopolitical and economic risks.

The extent to which growth expectations and investor sentiment are affected will hinge in large measure on the extent of Russia’s military involvement in Ukraine, as well as the response from the U.S. and the European Union. To date, Russia’s aggressive military move has been condemned widely across the globe and the West is now pursuing every diplomatic avenue to prevent a situation. These factors suggest that from the current standpoint, the likelihood of a large-scale military conflict between Russia and Ukraine is limited.

Second, as a result of the breakdown in relations between Ukraine and Russia, the current situation in Ukraine also contains imminent financial risk.

It has been estimated that in order to refinance their external debt in 2014, Ukraine would need between $20-$30B USD. After the new government took office in Ukraine last month, Russia revoked its $15-billion financial aid package. One potential solution to this issue is for the International Monetary Fund to step in to negotiate a new bailout package with Ukraine; however, the timing and terms of any such package are uncertain.

At the same time, Russia has experienced increased capital outflow recently—causing its central bank to raise its main interest rate from 5.5% to 7%, which in turn negatively impacts growth expectations for Russia.

Immediate impacts: Short-term volatility and sentiment swings

Currently, the most-impacted market is Russia. Russia is a leading energy producer and the third-largest trading partner with the European Union. Over the course of March 3, the Russian stock market index MICEX (The Moscow Interbank Currency Exchange) fell 10.79% in local currency terms, while the Russian ruble tumbled 2% against the U.S. dollar. On March 4 we saw MICEX rise 5.26% and the ruble rose 0.18% against the U.S. dollar.

At the current stage of the situation, we expect to see uncertainty-induced short-term volatility and sentiment swings in the market. As is typical during recent periods of uncertainty, safe haven assets attract more attention, as investors seeking to reduce risk in their portfolio. Gold and Treasury Bills typically benefit from such “risk-off” sentiment in the short term.

Impacts over time: An expected return to market fundamentals

For the time horizons for our client portfolios, and based on what is known, our view is the unfolding situation is likely to have limited global impact. Specific short-term impact is likely in crude oil prices that may be pushed up in fear of any disruption in supply; equities in European emerging markets and across developed Europe are also likely to experience volatility, as the situation is expected to impact these regions most.

As the situation becomes clearer or more contained over time, we expect that global markets will return to their pertinent fundamentals. We will continue to monitor developments in this region carefully to assess any impact on MD investors.

For investors looking to benefit from global economic and market growth, our view continues to be that the best plan is a diversified, tested investment strategy, tailored to your specific time horizon and purposes. While sources of market instability can and do change over time, the wisdom of this approach remains consistent.

As always, your MD Advisor is available to help you understand how global economic and market developments impact individual investors. If you have questions, I encourage you to contact your advisor.

William R. Horton, Jr., CFA
Chief Investment Officer
MD Financial Management Inc.