What Russia’s Invasion of Ukraine Means for Investors

In the short run the question is how much fear dominates. Anyone who bought Russian ruble-denominated stocks after the market’s astonishing 54% drop in the first two hours of Thursday’s trading was rewarded by an equally astounding 42% rise in the next half an hour. Similarly, U.S. stocks fell hard at the open, but ended with the Nasdaq-100 index having its best day since March last year as 2022’s equity losers turned into winners. Volatility is likely to remain extreme as the bloodshed continues and sanctions ramp up.

Tempting as big short-term price swings are to the market’s gamblers, investors should pay close attention to the long-run shifts that Russia’s move will intensify, because they probably mean more inflation and slower growth. They come in three parts:

Military spending reached its lowest as a share of the global economy in 2018, according to the Stockholm International Peace Research Institute. The pressure to spend more was already visible in Europe and East Asia as concerns grew about renewed threats from Russia and China, but the Ukraine invasion means more spending on weapons is inevitable.

Defense stocks should benefit, and aren’t especially expensive, with Datastream indexes that exclude big civilian aerospace companies, which were hammered by the pandemic, trading at 15 times predicted earnings in the U.S. and 10 times in Europe. In early Thursday trading, stealth bomber-maker Northrop Grumman had among the biggest U.S. stock-price gains, while British and French defense contractors

BAE Systems

and Thales were among the best-performing European stocks.

The bigger picture is that more military spending means less spending on other parts of the economy. If unemployment was high this would be less of a problem, but with the world economy already struggling to keep up with demand, it means more long-term upward pressure on inflation.

Less globalization is a natural result of a new Cold War, and a major challenge. Europe is reliant on Russia for natural gas, and Russia and Ukraine together produce one-quarter of the world’s wheat, as well as one-third of palladium and the vast bulk of the neon used in semiconductor production. China is the world’s biggest exporter, and almost every supply chain relies on Chinese sourcing for something. Breaking the rest of the world’s dependence on Russia, let alone China, is a multidecade project.

However, the trend toward more local production has been under way since the 2008 economic meltdown, with exports falling as a share of gross domestic product, and was accelerated by many corporate management teams after the pandemic created massive supply-chain problems. Previously, global trade had grown in importance almost continuously from the start of Russia’s glasnost policy of opening up in the mid-1980s.

Investors have already woken up to the need for new sources of energy that produce less carbon, and clean energy stocks were the best performers on Thursday. Now governments need new sources of energy that don’t rely on foreign rivals, so that low-carbon shift could be accelerated—although so could drilling for gas and oil in friendlier regions.

For investors, the impact is unpleasant. Higher energy prices and domestic sourcing hurt profit margins, because companies have to pay up rather than shop globally for the cheapest. If companies try to recover the margin by raising prices, it means more inflation. If they try to recover it by cutting other costs, it hurts growth. However it is done, using resources in a less productive way is bad for the economy, even if it is the right thing to do.

Geopolitics is scary again. It isn’t only Russia and China. Ukraine gave up its Soviet-era nuclear missiles in return for a promise from Russia, the U.K. and the U.S. “to respect the independence and sovereignty and the existing borders of Ukraine.” 

It is easy to see why a small country with powerful ruthless neighbors, or that doesn’t get on with the U.S., would see Ukraine’s fate as a reason to secure nuclear weapons, even if realistically, Kyiv could never have kept its nukes. Even countries currently under U.S. protection, such as Japan and South Korea, might reasonably worry about the reliability of their ally given the state of domestic American politics, and want nuclear deterrence.

Geopolitical tension has a tendency to spread. After Ukraine, the next in line is Taiwan, which China insists is a breakaway region. But even if China dials down the rhetoric across the Taiwan Straits, investors should expect a bigger discount on risky assets to take account of geopolitical risks, at least until memories of Russian tanks advancing on Kyiv fade.

These long-term trends aren’t really priced in, and the focus for now is on short-term issues of Ukrainian resistance, the extent of Western sanctions and whether the conflict could spread.

Investors can’t ignore the short-term effects. Already on Thursday markets were helped by the expectation that the Federal Reserve would lift rates at a less-frantic pace. But the prospect of a new era of geopolitical rivalry will hit the market’s long-term prospects, and bears close attention.

Write to James Mackintosh at james.mackintosh@wsj.com