Before the recent events in the Black Sea, few investors, financiers or market commentators would have been able to place Crimea on a map, much less appreciate its impact on the global financial markets, investment portfolios and stock market risk. The events of the past several weeks in the Ukraine and Crimea have captured everyone’s attention as hot headed media analysts talk of a new Cold War and Putin’s annexation of Crimea. The truth is much more complicated than that and the impact of these events is much more subtle than the headline grabbing sanctions against Russian oligarchs seeking to fill their shopping bags in New York or London.
The Ukraine has been at a crossroads of east and west, Europe and Asia for hundreds of years and ethnic boundaries are rarely as easily drawn as the maps we use to find these distant lands. Elections over the past several years have worn out these historic fault lines – the east pulling towards Russia and the west aspiring to join the EU. Historically, the Russians, the Poles, the Austro-Hungarians and the Ottomans (to name a few) have battled and controlled these lands at various points in history pulling the country, its borders, its culture and religion in different directions. During the second world war (or the Great Patriotic War as the Russians and eastern Ukrainian’s refer to it), these tensions were strained further as fascist resistance to communist forces moving west made a hero out of Ukrainian Insurgent Army leader, Stepan Bandera (to western Ukrainian’s) (in 2006 a statue was erected in the central square of Lviv.) While not the majority of protesters, members of the extreme nationalist right wing who were involved in driving President Yanukovych out, draw much inspiration from Bandara’s fascism and rumors are rampant about the extent to which right wing protesters were involved in scuttling the compromise, which ultimately lead to the departure of Yanukovych and then subsequent Russian action in Crimea.
For eastern Ukrainians, where Russian influence has been stronger, particularly after the second world war, the actions of the far right bring back memories of the battle against fascism that scorched the Ukrainian homeland. To disregard their anxieties is to simplify the dynamics of this land to an us vs. them and Putin vs. the west level. The situation is much more complicated than that. The Crimean peninsula is 60% ethnic Russian, followed by approximately a quarter Ukrainian and more than 10% Crimean Tatar. While the majority of the people are ethnic Russians (not quite the 97% that voted to join Russia), the Ukrainians and Tatars (a predominately Muslim group) have complex histories with Russian persecution and deportation. In 1954, Nikita Khrushchev transferred Crimea to Ukraine in a moment of historic symbolism that many Russians have yet to come to terms with. The dynamics of the military and economic relationship between Russia and Ukraine reflects this turbulent past. In 1994, the Ukraine gave up its nuclear weapons (the third largest stockpile in the world at the time) in exchange for a promise from Russia (and the US) to not use force or threaten military action against it. Energy policy further complicates the Ukraine’s position in this crisis as natural gas pipelines that power western Europe, namely Germany, run through Ukraine. Russia has not hesitated to use this lever in the past and is one of the primary concerns for the US and Europe as they negotiate with Putin.
What does this mean for your portfolio? It feels like we have been asking that question with greater frequency in recent years in response to crises in countries and regions that play small, if not miniscule roles, in global finance. Whether it is Greece, Cyprus or South Ossetia in 2008 (the last time Russia annexed a former territory), small changes in financially insignificant locations can have an unhealthy impact on your portfolio. It is a symptom of our globalized world that financial systems have become even more interconnected, creating a complex financial system, where risk is not easily defined and relatively small initial events can create large impacts in far off places – a financial butterfly effect. In the past two weeks, Russian markets have crashed and rallied (the Market Vectors Russia ETF Ticker: RSX has dropped by a third since last November when the crisis started and is experiencing three times its normal volume), foreign central bank holdings at the Fed have plunged by $106 million in a week (the biggest one week drop on record and presumed to be Russia shifting its holdings to protect the ruble) and the propaganda continues to run rampant from east and west. The actions of past weeks could be the impetus to jump start a transatlantic trade deal as the US has plenty of shale gas to offer, on better terms than Russia. The current geopolitical skirmish could quickly turn into an economic tit for tat – history is littered with trade wars that lead to real wars and the unraveling of monetary systems (for a great summary see the excellent book by Jim Rickards, Currency Wars).
As portfolio managers, we may not be able to predict every event, but we can build better portfolios than ever before – the tools are there that allow investors to manage risk. We can incorporate diverse assets classes and different strategies (tactical vs. buy and hold) with the goal of building a better portfolio that can withstand greater and more unpredictable shocks. There is no crystal ball, but during a year where we celebrate the 100th anniversary of the Great War, it bears noting that small events in places like Sarajevo can lead to unexpected and significant outcomes. It is too early to tell where the dust will settle in Ukraine, but to quote Art Cashin, “stay wary, alert and very nimble”. – PJ Grzywacz