The Independent Market Observer

3/3/14 - Ukraine, Uncertainty, and the Financial Markets

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Mar 3, 2014 11:35:59 AM

and tagged Market Updates

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Over the weekend, as you no doubt have heard, Russia reportedly executed a military takeover of the Crimea region of Ukraine in response to last week’s pro-Western revolution. Markets are reacting this morning to the immediate fact of Russia’s action. As investors, we need to think about the context and likely outcome of the immediate situation before we respond.

First, let’s consider whether this is a short- or long-term action. For all the talk of bringing pressure on Russia to reverse the situation, the reality is that the West’s ability to exert any kind of meaningful pressure is limited or nonexistent. Without actually committing military force, we cannot effect change. Europe depends on Russian natural gas to heat its homes and operate its economy; Russia remains a major oil supplier to world markets. It’s impossible to cut Russia off economically, since Europe and world markets depend on it too greatly. From a military perspective, it’s the area’s strongest power. There’s no clear course of action for the West.

Second, let’s look at a bit of recent history. Russia has invaded, and leveled, Chechnya—with no meaningful Western response. Russia invaded Georgia and took over parts of the country—which it still holds—again, with no meaningful Western response. Russia holds parts of other countries as well. The takeover of the Crimea differs in degree, not in kind, to a well-established Russian policy. Russia has repeatedly demonstrated that it will use force to protect its interests in nearby countries—and that the West will do nothing about it.

Third, let’s consider Russia’s perspective. Geographically and economically, Russia needs the Ukraine to become a great power. Without it, Russia is resigned to third-class status as a country. No country willingly accepts that demotion—any more than the U.S. would accept, for example, the southern half of the country trying to secede. This is not to defend the action, but to understand it.

Putin knew that by ordering troops to the Crimea region immediately after the Sochi Olympics—an event designed to re-introduce Russia as a modern nation—he was risking that $50 billion investment, as well as putting Russia at odds with the West. It was a deliberate, calculated decision—and unlikely to be reversed.

Given all of these factors, this is a long-term situation, and one which the world will have to accommodate. Bear in mind, however, that any market reaction to this takeover is likely to be short term. This action will create a new normal—and the markets will adapt.

Does this mean the Ukraine situation is not important? Certainly not. What needs to be watched is how the market deals with the uncertainty this creates. As I have mentioned before, current prices are based on pretty much everything continuing to go well—the economy expanding, profit margins rising, and no disruptions to anything. This situation in the Ukraine reminds us that—in reality—something is pretty much guaranteed to go wrong, which can lead (and probably will in this case) to many more things going wrong. We have seen a pullback today in share prices, and if things continue to decay, that will probably continue. The lesson found here is to plan for uncertainty—as I expect we will be seeing more of it.

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