Spring has arrived in the Northern Hemisphere, but warming temperatures have done little to thaw ice-cold tensions on the shared border between Russia and Ukraine.

In fact, the arrival of spring appears to have heralded an escalation in this now long-running conflict. Both countries have bulked up their military presence on the border in recent weeks, and regional observers have suggested the situation may soon transform into a full-scale war.

Investors and traders may therefore want to start monitoring the situation in Eastern Europe extremely closely, because if the United States gets sucked into what’s widely known as the “Russo-Ukrainian War,” there may be serious ramifications for the global financial markets.

And while an escalation of this conflict may not technically qualify as a “black swan,” it’s possible that the ultimate market impact could be reminiscent of one.

One key element of black swans is their unexpected nature—generally, they are defined as highly impacting market events that seemingly come out of nowhere. The latter technicality is one reason that a market correction linked to the war wouldn’t necessarily be classified as a black swan because the Russo-Ukrainian conflict has been going on for more than seven years.

Background on Russo-Ukrainian War

As most are aware, hostilities began back in February 2014 when Russian-backed forces quietly entered Ukrainian territory in Crimea. That incursion ultimately resulted in the complete annexation of Crimea by Russia—an act that was instantly met with strong condemnation by the global community. To this day, most countries in the world continue to view Russia’s occupation of Crimea as an illegal act.

Unfortunately, Crimea represented only the first phase of the dispute.

Later in 2014, Russian-backed forces slipped across another section of the border with Ukraine, east of the country’s capital. As a result, that region of Ukraine—encompassing Donbas, Donetsk and Luhansk—has essentially been cut off from the central government and has been transformed into a semi-autonomous zone plagued by sporadic fighting between the two sides.

All told, it’s estimated that 7% of Ukrainian territory is now occupied by the Russian military or Russian-backed militias, and that more than 13,000 lives have already been lost in the war.

There’s a myriad of other details that could be highlighted about this conflict, but the most important takeaway at this time is the possibility that the war could soon escalate beyond the point of no return.

On April 15, U.S. Air Force General Tod Wolters opined that there is a “low to medium risk” that Russia could invade Ukraine in the next few weeks. Ostensibly, that would seem to imply that Russia might openly declare war on Ukraine, with final objectives that aren’t clearly understood.

Wolters’ opinion matters not only because he is the top U.S. military representative in Europe, but also because he’s the supreme allied commander for the North Atlantic Treaty Organization (NATO) in Europe.

NATO was created in the wake of World War II to formalize the collective defense of its members from outside threats. At this time, there are 30 member-countries in NATO—up significantly from the original 12.

While several Eastern European countries are full members of NATO (Bulgaria, Poland, Romania), Ukraine is not one of them.

However, in June 2020, Ukraine joined NATO’s “enhanced opportunity partner interoperability program.” This program was founded in 2014 with the intent of deepening ties between NATO and countries designated crucial to NATO operations.

It’s vital to keep in mind that a key aspect of the NATO treaty revolves around the fact that “an attack on any NATO member shall be interpreted as an attack on the overall alliance.” That’s an important distinction when one considers that Ukraine is not a full member of the group.

However, there’s a lot more to this particular story.

U.S. Role in the Conflict

Nearly three decades ago, Ukraine took steps to ensure its regional security by signing onto the Budapest Memorandum on Security Assurances.

The purpose of this political agreement was to provide security assurances to certain countries that agreed to give up their nuclear arsenals after the dissolution of the Soviet Union—specifically Belarus, Kazakhstan and Ukraine.

In exchange for these promises, other signatories of the memorandum guaranteed they would help protect the “territorial integrity and political independence” of those nations going forward.

Signatories to the Budapest Memorandum included Russia, the United Kingdom and the United States.

At the time of signing, Ukraine possessed the third-largest sovereign stockpile of nuclear weapons on earth. Lately, many are likely wondering whether Russia would have dared to invade Ukraine if it still possessed a nuclear deterrent.

Regardless, the Budapest Memorandum ended up lasting about 20 years—until Russia scrapped its guarantee and advanced into Crimea.

At the outset of the invasion, Canada, the United Kingdom and the United States quickly condemned Russia’s actions and cited the Budapest Memorandum as evidence that Russia had broken its word.

Russia responded by claiming it was merely supporting “revolutionary activity” in Crimea and Donetsk, suggesting that Ukrainian citizens in those regions were seeking to break away from the central government in Kyiv.

Unfortunately for Ukraine, assistance from the United Kingdom and United States has fallen well short of the promises implied by the Budapest Agreement. So far, the two countries have sent money and equipment to Ukraine, but nothing more substantial in terms of “boots on the ground.”

Seeking to de-escalate the situation, President Joe Biden of the United States recently called for a summit with the President of Russia to discuss potential non-military solutions for resolving the conflict. That gesture appears to have temporarily soothed tensions, but for how long is anyone’s guess.

Complicating matters further, the United States not long ago deployed fresh economic sanctions against Russia—a move that could make a diplomatic resolution to the war even harder to come by in the near term.

The purpose of the most recent sanctions was to punish Russia for its continued interference in American domestic affairs (i.e. SolarWinds hacks, election meddling, etc.). And recent action in international currency markets suggests those sanctions are hitting the mark.

Over the last several years, the value of the Russian Ruble has fluctuated between roughly 60 and 80 per dollar. But in recent weeks, the Ruble has sagged toward the lower end of that range.

Russian citizens suffer immensely from devaluations in the Ruble because it impacts their ability to purchase imported products and to travel abroad.

Outside of diplomatic dialogue and sanctions, President Biden obviously has military options at his disposal, as well. The most extreme scenario would involve sending American servicemen into Ukraine.

However, Biden could also opt to send American naval vessels into the Black Sea. This option is likely preferable in the near term, because the Black Sea technically represents international waters and wouldn’t require the United States to cross that mental red line of deploying American troops within Ukraine’s sovereign territory.

Potential Impact on the Financial Markets

No matter what course of action is adopted by the United States, international energy markets will undoubtedly be on edge until the threat of war subsides.

Due to Russia’s vast reserves of fossil fuels, the country holds considerable influence over global energy markets. An agitated Russia could cut supplies to the market—effectively driving up prices for worldwide businesses and consumers. Higher energy prices, especially of the extreme variety, tend to throttle economic growth.

Fortunately, Russia’s influence over global oil markets isn’t as strong as it once was, due to record levels of oil production in the United States stemming from the shale boom. Thanks to new extraction technology and methodologies, the United States can produce as much oil as any country on earth, save Saudi Arabia.

As a result, the American energy sector could benefit significantly if the Russian-Ukrainian conflict intensifies. That’s an interesting prospect because the energy sector was one of the worst performers in 2020, and has already started 2021 on a high note.

Beyond oil markets, one also has to consider what might happen to global stock indices if Russia invades Ukraine.

Historically, global stock markets have actually performed fairly well during, and after, global military conflicts—especially in modern times. But past performance is of course never a guarantee of future returns.

According to research conducted by Shane Oliver, there can often be an initial shock in global stock markets when an international war first breaks out. However, fear in the markets (associated with armed conflicts) tends to subside over time, and stock market returns have historically been strong in the wake of such events.

The graphic below illustrates how stock markets have tended to correct at the outset of significant international armed conflicts, but also how they tend to recover and trade higher in the aftermath.

Source: BusinessInsider.com

The data above should help investors and traders better understand the potential market risks associated with a full-scale war in Eastern Europe—if one does materialize.

Readers seeking to learn more about tail risk in the financial markets (aka black swans) may want to review a past installment of Market Measures on the tastytrade financial network.

To follow everything moving the markets, TASTYTRADE LIVE—weekdays from 7 a.m. to 4 p.m. CST—is also recommended.

Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to support@luckboxmagazine.com.