Ukraine Conflict A Hinge Point for ETF Investors

Russia’s military invasion of Ukraine has had tremendous military, humanitarian, and economic consequences globally. In the world of investing, Russia’s decision to stop trading on the Moscow stock exchange had direct implications for investors in Russian and emerging market ETFs. To get insight into the conflict and its implications, I spoke with John Lunt, President of Lunt Capital Management. Lunt Capital is a Utah-based, SEC registered independent investment advisor that offers tactically managed investment strategies to individual investors as well as third-party asset management solutions to financial advisors. In addition to being an expert on ETF based portfolio construction, John has a 30-year personal and professional association with Ukraine and is an expert on the region. Through this discussion, it became apparent that this conflict could represent a landmark investment moment. Summarized below are the key themes addressed in the discussion, including John’s observations on the longer-term implications for investing and global asset allocation.

Summary of Key Themes

Status of the military conflict

Almost a month into the conflict, it is difficult to make definitive short-term predictions. In the long run however, Ukraine will prevail, it is a matter of time frame and at what cost. They seem very committed to defending their country, their families and their freedom. So much of the shorter-term military outcome is conjecture, so it must be scenario driven. The high probability scenario is where it is a war of attrition, where the staying power of the Ukrainians simply outlasts the ability of Russia militarily, economically, casualty wise to continue. Some cities may fall to Russian control, but Russia won't be able to hold them or govern them. There's also a scenario where it may be shorter where we see that the cost to Russia is so significant, that they recognize they're not going to achieve their aims, and that it ends sooner.

Economic outlook for Russia

There is a significant possibility of a sovereign debt default in Russia. Over the course of just a handful of weeks, Russia has really become kind of an economic pariah. Russia has enormous natural resources, and there will be emerging markets that are going to be willing to do business with them. But from the perspective of banking trade and capital controls, Russia is significantly isolated. Even in the event a diplomatic arrangement is reached in the next few weeks or months, the economic damage to Russia is going to be much more long term.

Impact on global indices underlying ETFs

On March 9, MSCI reclassified Russia from being an emerging market to being a standalone market. Effectively this means that Russian equities are no longer going to be included in MSCI’s broad emerging and global indices. Other index providers have taken similar actions. Russia has essentially become un-investable, so Russian ETF constituent holdings in indices and ETFs are effectively written to zero for now. Even prior to the invasion, the weight of Russia in MSCI’s emerging market index was in long term decline, and it was only 4% at the start of 2022. So, the impact is more significant on investors holdings Russia specific ETFs rather than broader emerging market ETFs.

Energy market outlook

The consensus view is that we will see elevated energy prices in the intermediate term. There is going to be increasing global pressure on OPEC and similar domestic pressure in the US to increase production. The challenge is that these aren't just light switches that turn off and on. There's significant investment in either reducing or increasing capacity when it comes to energy, so it will lead to elevated energy prices going forward. Alternative energy sources could take years to be a replacement and so that's not something that is going to immediately have an impact on energy prices. As we get into midterm election in the US, and then ultimately into a presidential election, there’s going to be a lot of pressure to increase capacity.

Impact on U.S. Fed policy

Prior to the invasion the consensus was a rate hike of 50 basis points in the March 16 meeting, but the war resulted in a 25 basis point hike instead. While there’s obvious concern about inflation and the Fed being behind the curve on that, now there's a real possibility where higher commodity & energy prices have a dampening effect on economic growth. Going forward it seems more likely that the tempo of hiking is likely to be slower out of this, and there's consensus that we're more likely to see 25 basis points per hike.

Second order effects of the conflict

While many investors are focused on energy, there could be significant second-order effects. There is likely to be an impact on global food prices, and countries, like those in the Middle East, that have significant imports of agricultural products from Ukraine. The impact goes beyond just the energy commodities, into other commodities such base metals and agricultural products. That seems to be the clearest next order of impact.

Long term implications for portfolio construction

For the last 20 years, globalization has been the key theme and the whole world, including China and Russia, was part of the investment opportunity set. Now investors may look at global asset allocation differently. Investors may start to look at ETFs of countries with more economic and political freedom. Recently there's been so much focus on ESG, but for many investors, the concept of freedom has not always factored explicitly into ESG. This is going to change that mindset.

There’s also going to be more focus on supply chains for companies and the geopolitical risks associated with that. It's not just the physical supply chains, but also using offshoring and being exposed to political risks with your labor force. The assumption that more economic integration was going to lead to more open markets is going to be challenged in a material way. It's going to impact how people look at emerging markets within their asset allocation. This is a landmark investment moment and is likely to challenge the underlying assumptions that people have had about how the world of globalization works.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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