Economic News & Analysis—March 3, 2014

All’s not quiet on Russia’s Western Front

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

Ukraine is in turmoil, and it looks like Russia is going to ignore international calls to back out of Crimea. Russia has military interests in the Ukraine, especially with the Crimean region and its port in the Black Sea. Ukraine appears to be splitting in two, with part gravitating toward Russia and part toward the rest of Europe.

The USSR was a super power that fell into pieces in 1991. Russia, the largest of the former Soviet states, has been struggling to become a regional powerhouse since the tearing apart of the Iron Curtain. Many of the borders that emerged out of the dissolution of the USSR continue to be redrawn. The borders were likely originally drawn more for administrative ease for leaders of the Soviet Union than for building autonomous, self-governing regions. Clusters of ethnic groups have long-standing tensions that are cobbled together, which creates instability.

At the center of this is President Vladimir Putin. He served as prime minister from 1999 to 2000, president from 2000 to 2008, then again as prime minister from 2008 to 2012. By all appearances, Putin is trying to rebuild an empire, even if that means defying the wishes of his neighbors and the majority of the international community. Under Putin, Russia has cozied up to Syria, Iran, and Venezuela while defying the U.S. and its allies.

What should we expect? One precedent is the Russia-Georgia war in 2008. Georgia is a country that was part of the USSR, but Georgians believed that certain territories should be part of Georgia, while Russians thought they should be part of Russia. In August 2008, a military conflict effectively left the disputed regions under Russia’s control.

It’s not entirely clear whether the stock market took much notice of the conflict. It happened during the global financial crisis, but it caused no obvious move up or down in U.S. stocks. Energy stocks sold off pretty heavily, at least relative to the broader S&P 500 Index. Eastern European stocks and Russian stocks moved down significantly relative to the U.S. market, perhaps because of the conflict. German stocks actually held in there pretty well.

The Russian invasion of Chechnya in 1999 lasted more than nine years and was overseen by Vladimir Putin. From the start of the battle on August 26, 1999, to October 15—after Russia entered Chechnya—the S&P 500 Index dropped approximately 10%. However, that could have been due to factors other than the Russia-Chechnya conflict. Energy stocks performed relatively worse than the S&P 500 Index, but emerging European stocks did relatively better than even U.S. stocks in general.

Economic sanctions much like the sanctions imposed on Iran could be imposed on Russia, but they may have less bite. Putin’s play may be based on his assessment that the U.S. and its allies need Russia’s cooperation with Syria, Iran, and Venezuela more than Russia needs the approval of the U.S. or Europe. Europe’s dependence on natural gas from Russia may also make European leaders hesitant to do more than just condemn the Russian actions. Russia seems to be able to play its cards repeatedly, as evidenced by past actions—or, rather, lack of actions—by the international community in response to its aggression.

Although Russian stocks look cheap on a valuation basis, I think they are cheap for a good reason. If Russia antagonizes the rest of the United Nations, how safe is your ownership interest in a state-owned Russian company?

Perhaps the lesson from the Georgia and Chechnya experiences is that energy stocks are the most vulnerable. I think another important lesson is that risks can pop up unexpectedly. That’s what makes them risks, after all! It’s important not only to be diversified but patient, not putting your grocery money for the month ahead into stocks.

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