Three weeks have passed since the Russo-Ukrainian War. Despite the immeasurable costs of war in terms of human life and human capital and infrastructure, we have seen a lot of turbulence in financial markets. So what's going on so far?
As markets tend to react to geopolitical risks, Fed economists Dario Caldara and Matteo Ikoviello recently built a geopolitical risk index (GPR) to be able to compare events at different points in time.
Below you can see a graph of their daily data, which goes back nearly 40 years. The most notable peaks include the Gulf War in 1991, 9/11, the start of the Iraq War in March 2003, the London bombings in July 2005, and now the Russo-Ukrainian War. For those who are now looking for some sort of solace, the index argues that it is still not close to the level of geopolitical risk seen after 9/11.
Geopolitical Risk Index
High-ground political risks have been shown to increase uncertainty among investors, prompting stock prices and other financial assets to fall. The link to stock market uncertainty is particularly evident in the chart below, which compares GPR to the VIX indicator of stock market volatility, which is sometimes referred to as an indicator of investor fear.
The GPR daily line is orange, while the other two versions track threat risk (red) and geopolitical behavior (green). Essentially, they are all moving in the same direction, with the red risk line leading in the other direction. As you can see, after satellite imagery first showed Russian troops massing on the border with Ukraine, both the lines and the VIX rose in November. Other peaks correspond to January 26, the date of NATO's written response to Russia, and the start of the invasion on February 24.
Geopolitical risks and stock market volatility
GPRD (orange) = daily GPR. GPRD_Act (green) = geopolitical behavior. GPRD_Threat (red) = geopolitical threat.
Commodities proliferated
Energy markets, especially oil markets, react to geopolitical risks at their best. Given Russia's enormous importance as an oil exporter, energy prices were particularly affected by this war. Brent crude is currently trading at around $104 a barrel, up nearly $140 a few days ago. This will affect everything from corporate cash flow to consumer gasoline prices, creating inflationary pressures that could lead to a recession.
As Russia and Ukraine are also major exporters of many other important commodities such as wheat, neon gas, palladium and sunflower oil, their prices are also soaring — and they are destined to continue to rise because of Western sanctions.
Comparison of commodity and asset prices since the Russo-Ukrainian War
Brent Crude Oil = Blue; Wheat Futures = Cyan; Palladium = Indigo; Gold = Orange; Bitcoin = Yellow; US Dollar (DXY) = Purple; 10-Year Treasury = Green.
On the other hand, safe havens in times of volatility performed well. The price of gold rose significantly in the first few months of the pandemic. Bitcoin and other cryptocurrencies have the potential to benefit because they are a tool for Russia to circumvent sanctions, but recently they have been more moderate.
stock market
The stock market's response to war is more complex because different markets are more or less exposed to different commodities than other markets. They also have varying degrees of exposure to the Russian stock market (the Russian stock market remained closed after the Russo-Ukrainian war plunged with the ruble).
According to calculations drawn from the 1985 data, European countries are more relevant to the Russian market and therefore more vulnerable. For example, France, Germany, and the United Kingdom have correlations with Russia of 0.45, 0.42, and 0.47, where 1 indicates they are in step and 0 indicates that they do not interact at all. On the other hand, the correlation for the United States is 0.26, while interestingly, the correlation for China is only 0.1.
Stock market comparison
FTSE 100 (UK) = Blue; S&P 500 (US) = Orange; Toronto Stock Exchange (Canada) = Cyan; CAC 40 (France) = Yellow; DE40 (Germany) = Indigo; Shanghai Stock Exchange = Green; MOEX (Russia) = Purple.
Finally, what about the different types of companies? As you can see in the breakdown of U.S. players you see below, different industries performed very differently in the early stages of this crisis. The black line is the S&P 500, so those below perform poorly, while those above perform better.
Communication = Blue; Consumer Discretionary = Cyan; Consumer Essentials = Yellow; Energy = Indigo; Finance = Purple; Healthcare = Green; Industrial = Crimson; IT = Orange; Material = Red; Real Estate = Pink; Utilities = Lilac; S&P 500 Index = Black.
However, we should not be fooled into thinking that certain sectors will only benefit from the war. There may be winners in the short term, but the interconnectedness of the economy, the burden of sanctions, and the cost of increased uncertainty will ultimately affect all markets. This will affect household budgets, wages and pensions. Regardless of the final outcome, this remains largely unpredictable.