It’s hard to watch the news these days without hearing about the tug of war that’s going on between Russia and the Ukraine. As the situation has escalated, markets have reacted nervously: with sharp declines, particularly in Europe, followed by sharp increases and then more declines. The current crisis in the Ukraine is a stark reminder that non-financial events, such as geopolitics, can and do impact capital market outcomes.
Over the years, my firm has spent time identifying extreme risks. These are potential events that are unlikely to occur (and therefore are infrequent) but could have a significant impact on economic growth and asset returns should they happen.
Returning to the situation in the Ukraine, a likely impact of the Russian incursion into the Crimea is higher energy prices. Europe sources approximately 30% of its gas supplies from Russia, around half of which comes through pipelines crossing Ukraine, and any disruption to this supply could impact European growth.
Having said that, given the time of year, the mildness of the European winter so far and the response of many countries to previous Russian/Ukrainian tensions in 2006 and 2009 (building and filling large storage capabilities, upping use of Norwegian and Qatari oil and establishing other pipelines through countries other than Ukraine), it’s likely that the impact of the current Russian/Ukrainian situation will be more moderate relative to previous episodes. To date, oil prices have responded, but only moderately so. Further escalation of the crisis would be needed before this becomes of concern. In terms of “cost,” higher oil prices would definitely impact energy-importing countries.
From a pure investment perspective, the MSCI Emerging Markets Index has a 6% allocation to Russian securities. So investors with an exposure to emerging market securities may be positively or negatively impacted, depending on their manager’s view of Russian securities.
Another non-financial risk that may impact investors is the current drought in California, which continues despite the recent rainstorms. In fact, almost 95% of the state remains in drought. It’s believed that water shortages (and energy shortages, for that matter) are likely to occur once every 10 years, with an impact that can be quite significant, though local in nature.
Why would investors care about the drought in California? Well, it is impacting agricultural production, with cattle being sold due to lack of grazing lands and crop yields down. As such, price increases related to the drought are already being felt on Canadian grocery stores.
From an investment perspective, there are securities and/or assets that provide exposure to resources in shortage or that may benefit from the situation. The construction of a desalination plant in Carlsbad, Calif. is a perfect example. It’s being financed, in part, by pension funds and will provide desalinated water for irrigation, something that’s desperately needed by California. While California benefits, investors in the Carlsbad plant hope to receive a handsome return for their infrastructure investment, as well as ongoing income.
Another way to potentially benefit from the drought is through private or public agriculture. There are investments that are exposed to crops that could be substitutes for the fruits and vegetables that would otherwise be grown in California. Chile is a major producer of similar products and could help ameliorate the situation in California. Therefore, investments in agricultural land in Chile or in listed agricultural funds that invest in Chile could be quite profitable for investors.
It’s important when constructing investment portfolios that plan sponsors consider how their portfolios might behave in various situations, financial and non-financial. Committees often spend time on identifying and evaluating financial risks to their investment portfolio’s performance. As can be seen from the Ukrainian situation and drought in California, committees may also want to understand their non-financial risks and exposures as well.