The Global Analyst

On 24th February 2022, Vladimir Putin launches a “special military operation” against Ukraine in what the whole world now terms as a war. Markets globally reacted badly to this move. The S&P 500 (the bellwether index) fell 5% between March 2 and 8, while Sensex tanked approximately 6% during the same period. Initially, markets expected this event to end in a couple of days, but the war has now gone into second month, raising fears it won’t be ending anytime soon.

What is an extraordinary event? It can either be nature-imposed like tsunamis, earthquakes, floods and storms, or it can be man-made like terrorist attacks and wars. While natural calamities tend to be swift with known outcomes, man-made need not be swift and bears unpredictability in terms of eventual outcome. The event of 9/11 or the current Russian-Ukraine war is testament to such happenings. History is replete with war events, especially since July 28, 1914, when Austria-Hungary declared war on Serbia, which ultimately led to the First World War. Several geopolitical events have followed since then, such as Korean War (1950), JFK assassination (1963), Soviet-Afghanistan War (1979-1989), Iraqi invasion of Kuwait (1990), WTC attack (2001), Iraq war (2003) and Russia-Ukraine War (2022). This will not be the end and such events will keep occurring, though we cannot predict its timing. However, whenever such incidents happen, markets exhibit extreme volatility compared to nature-driven calamities. Nevertheless, if it is manmade or nature-induced, it will be instructive to see how markets react to such extraordinary events.

Generally, the market reaction will be in the form of increased volatility leading to dramatic fall (called drawdowns), also impacting currency/commodity markets as well, thereby leading to heavy selling by foreign institutional investors. For example, just as the Russia-Ukraine war began, it saw Sensex lose 8%, while the local currency fell by 2.5%. Oil prices too have peaked at $139/barrel. All this has seen FPIs turn net sellers; they have already sold securities worth $11 bn so far this year. Though the 30-scrip benchmark has recovered most of its losses and so has the currency, FPI selling continues. Thus, it is not unusual for markets to show extreme volatility during such events, though only to regain eventually.

Based on how these events unfold and how long they last, the government of the day tends to put in place economic measures that can smoothen the impact. In case, the war turns out to be prolonged leading to severe supply side bottlenecks resulting in increased commodity prices and therefore inflation, the government will increase interest rates as a monetary response. It may also unleash fiscal stimulus and raise borrowings to meet increased spending that will result in increased fiscal deficit. These steps will affect different industries differently.

So, the question is: In times like these, can investors spot opportunities? This is a tricky question. Unless we know in advance how long the scenario plays out, it would be risky to act as contrarian buyers. Hence, most of the investors will initially not enter, fearing the worst. A good example to cite would be the beginning of the virus outbreak towards March 2020. Many analysts then had predicted a U-shaped recovery for the economy, but it actually turned out to be a V-shaped one. Hence, anticipating a longer playout and waiting to indulge in bottom fishing can be dangerous if a material event ends swiftly. On the other hand, if one estimates these episodes to end quickly and therefore starts to buy immediately on dips, he/she may encounter several such opportunities in the down ride if it were to turn prolonged. Hence, the best response to investing in war times is to create scenarios and assign probabilities. It is also advisable to consider three scenarios, i.e., base case, optimistic and pessimistic.

Optimistic Scenario: In this scenario, we expect the inflation threat to evaporate in the near term. Presently, inflation is raising its ugly head in the US and other developed nations. The Fed, initially assessed this to be transitory, on the back of the reasoning that this inflation is driven more by supply bottlenecks than by demand surge. However, Fed quickly changed that position and is now using its monetary policy to manage surging inflation by increasing the interest rates steadily. To just put this in perspective, the long-run inflation in the US is about 1.5% to 2%, while the current inflation is about 7.5%. Also, the Covid pandemic is disappearing quickly in certain countries and reemerging in others (like China/ Europe). The optimistic scenario may envision a Covid that can move from being a pandemic to endemic globally. Also, optimistically we can hope for supply chain to unclog itself, leading to lower logistics and commodity prices. All these may keep the Fed in track with its usual rate increase plan. On top of this, we can optimistically assume that Russia and Ukraine will come to some sort of long-term understanding, thus swiftly ending the war. In this scenario, the economy and therefore the markets can recover and produce another bull year.

Base Scenario: In the base case scenario, one can assume that high inflation is here to stay for some more time and can accept that as the Âðnew normal Âð. In that case, Fed may increase interest rates slightly more than anticipated. While supply chain woes stay, they do not get worse. The Russia-Ukraine conflict becomes protracted but contained just between them without becoming a global issue. In this scenario, markets may stay flat, but may remain highly volatile.

Pessimistic Scenario: In the worst case scenario, the Russia-Ukraine conflict may spill over to other European countries, and thus NATO gets dragged into the war. This will send commodity prices, including crude oil, soaring, which will lead to high inflation on the back of severe supply chain disruptions. The economic impact of such a scenario will be market negative with earnings and valuations falling steeply.

While we lay out the factors under each scenario, it may be a good idea to assign probabilities for those scenarios. However, we should note to carefully shift those factors from one scenario to another as things unfold and add more factors as we go by. Such change/inclusion of factors should also result in reassessing the probability assignment.

Remember Each Event is Different

Analyzing past geopolitical events and their market impact can appear to be an easy exercise in hindsight since all the facts are known. However, analyzing an ongoing conflict and its impact can be a daunting task. It is important to understand while we can take many cues from history, we should never blindly extrapolate as each event is happening under a unique setting.