Thoughts on Financial Markets and the War in Ukraine
Dear friends and clients,
Like most of you, we are watching the unfolding catastrophe in Ukraine with deep concern. The prospect of over a million refugees, devastated cities, and thousands of deaths has cast a dark shadow over Europe. However, while there will be ongoing geopolitical repercussions from the conflict, and Europe is at potential risk of an economic downturn, the US is likely to be far less affected.
We would also note that stock market volatility around geopolitical events has historically been short-lived. In the dozen major conflicts of the past half-century affecting the US and its allies (including the Yom Kippur War, the Soviet invasion of Afghanistan, the First Gulf War, the 9/11 attacks, the Iraq War, the first Ukraine war, and the US intervention in Syria), the average market sell-off has lasted twelve trading days, with an average decline of -6%. Mundane as they may seem, inflation, employment, interest rates, and corporate profits are far more critical to investor returns. In the current moment, the trajectory of the pandemic should also be mentioned.
That being said, the best-case outcome in Ukraine seems to be a negotiated settlement. With sanctions ravaging the Russian economy, Ukraine suffering increasing destruction of its infrastructure, and tragic loss of life on both sides, we may see a softening of positions that would lead to a peace agreement and lifting of sanctions. Ukraine might forfeit its Eastern breakaway provinces and the prospect of NATO membership, while Russia might agree to withdraw.
As we have seen in Iran, Syria, North Korea, Venezuela, and elsewhere, however, authoritarian regimes that stifle domestic dissent have proven resilient in the face of severe sanctions and it is possible that Putin will insist on total subjugation of Ukraine regardless of international pressure. In this case, we would expect a longer war and permanent occupation by Russian forces or the installation of a puppet government in a now dismembered and impoverished country.
In either case, the conflict is bound to add to global inflationary pressures and worsen pandemic-related supply chain disruptions. The severity of price escalation will likely be tied to the duration of the conflict.
If a settlement cannot be reached quickly, energy and food prices will likely rise, and disproportionately impact European economic growth since the EU imports 40% of its natural gas and 25% of its oil from Russia. Ukraine for its part accounts for 8% of global wheat exports, 12% of barley, and 13% of corn. Higher prices for such essential commodities could in turn depress consumption and raise the specter of ‘stagflation’ in which high inflation coincides with economic stagnation. Central banks could face the unenviable choice of raising interest rates to control price increases while further choking their economies, or lowering them to support economic growth, risking runaway price escalation.
The economic damage should be far less severe in the US for a few reasons. Almost half a century after the Arab oil embargo crippled the American economy, the US achieved energy independence in 2019 and is now a net exporter of oil. The US is also the largest global producer and exporter of food, and therefore less affected by the supply-demand dynamics discussed above. Moreover, exports account for less than 12% of US GDP, compared to 29% for Russia and 43% for Europe, making us far less dependent on external demand.
Fortunately, the US economy was in a fairly strong position prior to the Ukraine invasion, with rising wage gains, increasing capital spending, low unemployment, and expectations for healthy corporate earnings growth in 2022. In addition, the easing of the pandemic has allowed people to return to more normal behavior and spending patterns.
Although the Federal Reserve will most likely stick to its plan of raising interest rates over the course of the year, a further round of fiscal stimulus (tax breaks, subsidies, etc) is not out of the question if the US consumer needs support. This generally positive backdrop, as well as the advantageous trade positions discussed above, should help insulate the US from the shock waves of the Ukraine crisis. Even if Europe slips into recession, the US economy may still be able to sustain a 2-3% growth rate.
The sell-off in the first two months of this year has also dropped stock valuations to more reasonable levels. Markets are experiencing more dramatic price changes as investors struggle to assess shifting risks related to the war in Europe. A widening of the conflict could cause further selling, but some of this risk is already reflected in lower market prices.
LongView’s portfolios are invested globally across asset classes–in equities, bonds, and alternative strategies–to diversify risk so that the positive performance of some holdings can help offset the negative performance of others. Roughly 10% of our equity holdings are also hedged using a rules-based options strategy (through the JP Morgan Hedged Equity funds) to protect from severe downturns. Our sustainable (ESG) portfolios have low exposure to fossil fuels and therefore don’t benefit from the sharp rise in oil and gas prices that has made the energy sector the only area of the market to be up year-to-date. Conversely, we also have lower exposure to some of the major fossil fuel consumers that are most likely to be hurt by these price increases (e.g. transportation and airlines). We are confident that we will make it through the current market turmoil and are positioned to capture the recovery, whenever it comes. We will be watching carefully should facts on the ground require a reevaluation of our positions.
With all our wishes for peace in the world and in our own lives,
