Over the weekend, leaders from the U.S., EU, Japan, Canada, and U.K. backed a new round of sanctions on Russia. Like previous actions, they appear to be crafted to exempt energy transactions between Europe and Russia, but it is unclear at this time if these additional measures will be successful at avoiding an energy shock. What is becoming clear? The Russian financial system will likely face substantial stresses. The EU's hardening resolve to embrace these new, tougher sanctions along with NATO arms shipments to Ukraine suggests that the conflict and its costs may continue to grow. In the near-term, these events may drive even more of the market swings we wrote about on Friday in Russia-Ukraine: Navigating Markets on Edge.
We wrote on Thursday: "Should Russian banks be restricted from the SWIFT payment system, making it much harder for Russia to export oil, it may push energy prices higher for the rest of the world at a time when inflation is well above average." Although the statement released on Saturday made it clear that only Russian banks already being targeted with prior rounds of sanctions would be removed from SWIFT, the ban could be extended to additional banks, if necessary. It is unclear which banks beyond the five lenders that were named in prior sanctions may be targeted which makes it hard to assess the impact of the partial SWIFT ban. Russia was home to more than 360 banks at the start of this year. We are watching to see if Gazprombank becomes a target since it handles a large share of Russia's energy exports.
The sanctions are designed to hurt Russia's economy while minimizing impacts to global energy and agricultural supplies and attempting to avoid a "stagflationary" (the combination of high inflation and low growth) shock on the rest of the world. At this time, U.S. and EU leaders are not targeting Russian energy exports and Russia is not threatening to cut off oil and gas shipments in retaliation to these sanctions. Because energy makes up 60% of Russian exports and 30% of its gross domestic product, Russia may be more inclined to reap the windfall from high prices than to deny itself critical revenue at a time when its economy is at risk of recession. If the new sanctions do not severely curtail Russia's ability to sell energy, the risk of major economic disruptions could be reduced. Yet, the more pressure that is applied by expanding sanctions, the greater the risk energy supplies could be cut off by Russia. Of course, the war itself could also result in interruption if gas pipelines that transmit gas to Europe through Ukraine are damaged.
Russia's trade relationships
Source: Charles Schwab, US Census Bureau, European Commission, Data for 2020 retrieved as of 1/28/2022.
There are a potential offsets to any possible energy shortages. The U.S. appears close to a nuclear deal with Iran that would bring much-needed supplies to the market at a critical time. Also, winter is ending in a few weeks, reducing demand for energy to heat homes and businesses. Europe reports that it already has prepared enough natural gas supplies to withstand an immediate shock or supply cutoff.
Russia's central bank and its foreign currency reserves are being targeted to hinder its ability to support the value of Russia's currency, the ruble. Based on data from the Bank of Russia's monthly reports, Russia's available foreign currency reserves may have been cut by as much as one-fifth of what they were on Friday. The sanctions include limiting Russia's ability to draw on its credit lines at the International Monetary Fund or access to its funds at the Bank for International Settlements. However, the released statement was unclear about the extent of the freeze, appearing on the surface to be a limited restriction tied to certain activities.
Russian ruble hits new low
Source: Charles Schwab, Bloomberg data as of 2/27/2022.
The ruble has fallen to new a new low versus the U.S. dollar, making imports more costly and boosting inflation in Russia. Russia has already chosen to impose capital controls, and may limit conversion from rubles into dollars, and even limit daily withdrawals from bank accounts in attempt to prevent further decline of its currency and runaway inflation. These efforts may also further impact the Russian financial system and economy.
There are other impacts from this weekend's developments that bear watching for investors.
- Bank failures - The sanctions are likely to push Russia into a recession and may cause overseas subsidiaries of some Russian banks to fail, but these are very likely too small to create a global financial crisis.
- Supply chain woes - The conflict may have a small impact on already stretched global supply chains. Volkswagen will suspend production at two factories in eastern Germany that make electric vehicles because fighting has interrupted deliveries of critical parts from Ukraine.
- More defense spending - Germany's government announced it would spend an additional €100 billion, or 3% of GDP, on defense this year and spend at least 2% of GDP per year starting in 2024. This could set the tone for looser fiscal policy from other Eurozone governments, partially offsetting the economic drag from higher energy costs.
It's not yet clear how impactful the latest round of sanctions will be on energy flows and financial markets or whether they will do much to help ease the violence in Ukraine in the coming days. Last week, President Biden cautioned that it could take weeks or months for the effects of sanctions on Russia to be felt. Yet, new developments regarding the military and financial battles are coming fast.
In the near-term, markets are likely to continue the swings seen last week as developments unfold. What is more certain is that Russia's stock market—which accounted for 2% of the MSCI Emerging Market Index at the end of last week (with more than half of that in two energy companies and a bank targeted for sanctions)—is likely to be much smaller this week.
Market reaction to geopolitical events involving Russia since the fall of the USSR
Source: Charles Schwab & Co., Inc. and FactSet. Data retrieved 2/24/2022.
*Turkey is a member of NATO, now and at the time of the event.
Data retrieved 2/24/2022. All price performance is in USD. Past performance is no guarantee of future results.
A long history of geopolitical events suggests that long-term, diversified investors may not need to take defensive actions in their portfolios, as seen in the above table. That said, as we forecast in our 2022 Schwab Market Outlook, we believe this will continue to be a year of heightened volatility that will test some investors' tolerance for risk.