About Ukraine and Russia …

Violence between "pro-Russian separatists" and the Ukrainian military in eastern Ukraine continues. More sanctions from the West are being piled on Russia for its role in allegedly sponsoring these rebels. The death toll continues to mount, including some innocents caught in the crossfire aboard a Malaysian Airlines flight from Amsterdam to Kuala Lumpur Thursday, in what seems to be the bloodiest episode to date. These events took center stage Thursday, with many in the financial press postulating markets would surely shake in response. Despite the shifts in specifics, our position remains unchanged: For the Ukraine crisis to have a material impact globally, it has to escalate far beyond its present level.

Since we last touched on the conflict in Ukraine, there have been some shifts worth noting, though they don't much affect our view of the equity-market impact of the fighting (which we expect to be minimal barring major escalation). Several Ukrainian aircraft have been downed, including a military transport jet in June, another in July and a fighter earlier this week. The cast of characters has shifted some, with Ukrainian voters electing billionaire chocolatier Petro Poroshenko president on May 25. Poroshenko is a strong anti-Kremlin figure, his business having been targeted by Russian economic measures in 2013, and was a major force in the demonstrations that led to the ouster of Kiev's formerly pro-Russian government. Upon taking office, he supported a unilateral ceasefire aiming to quell conflict. But the rebels didn't cease firing, and Poroshenko fired-launching a major new offensive July 1. That offensive put the separatists on their heels, with Russia staying mostly quiet until a stray shell hit Russian territory in mid-July, killing one. Russian Deputy Foreign Minister Grigory Karasin claimed "it would not be left without a response," and that response has reportedly taken the form of additional military and logistical support for the separatists.

That support triggered a response from the West. Over the July 12/13 weekend, the EU announced it would add 11 more individuals to those already sanctioned. The US followed suit Wednesday night, with President Obama announcing he would sanction four Russian companies, including Rosneft, Russia's national oil firm, Gazprombank (a bank related to gas giant Gazprom) and two others. In announcing the measures, Obama claimed they would "hit the Russian economy hard," and Putin has vowed to respond. We presume the intent is to hit harder than the initial round, which has proven largely feckless. US/Russia trade data show declining imports since March, but only slightly so. Russian GDP growth slowed to 0.9% y/y in Q1, but that's not out of step with the prior year's quarterly year-over-year growth rates of 0.8%, 1.0%, 1.3% and 2.0% respectively. Russian stocks took a dip out of the gate, but as Exhibit 1 shows, the MSCI Russia Index soon rebounded.

Exhibit 1: MSCI Russia and Events

Source: Factset, MSCI Russia Index, net returns in USD, 12/31/2013 - 07/16/2014.

The new US sanctions seem to have little chance of more material success. For one, the four companies sanctioned are little involved with the US. Russian oil constituted 4.2% of US oil imports in April 2014 (the most recent data)-a small increase from before conflict began. Plus, the activities banned are narrow and targeted. Rosneft's joint ventures with western oil firms appear unaffected. The banks in question can still use western payments systems firms' technology and clearing. And the only real hit is the closing of US-based funding markets for them-though the market addressed that months ago. Few Russian firms are floating long-term bonds on US capital markets. The sanctions merely seem to formalize that.

If the sanctions seem unlikely to severely hit Russia's economy-which is less than 3% of world GDP-they are even less likely to hit the world much. And Russia's capital markets are even smaller. The MSCI Russia Investible Market Index-a gauge covering 99% of Russian stocks by market capitalization-clocks in at only $223.6 billion in total market cap, about one half of one percent of global market cap.^[i] Some individual stocks outside Russia exceed that.

Yes, fears may shake stocks some in the short term, but without a global escalation, there likely isn't the size necessary to cause lasting negativity. While it remains to be seen how the West responds to the downing of the jetliner, as Europeans and Americans are reportedly among the victims, similar situations like the downing of the Korean Air Lines jet in 1983 over Russia didn't lead to war with the West. And at this point, it's unclear whether Russia was directly involved in the downing of the Malaysian plane or not. There are too many possible outcomes to handicap what happens in response this time. Maybe more sanctions. Maybe stiffer sanctions. Maybe nothing. Maybe a military response. Maybe this is the signal that gets Russia to stop supporting separatists. All are within the realm of possibility. But unless the probability of a major escalation rises, we'd suggest Ukraine remains a tragedy devoid of material market impact.