For the second time in two years, global capital markets have become unsettled by world events. And for the second time in two years, we were already in the process of reducing portfolio risk when these destabilizing events occurred. Our portfolio management decisions were not prescient. The closest one can reasonably come to such a suggestion relates to the generalizations conveyed at the end of our most recent communication. At any moment, stocks are either inexpensive, fairly valued, or expensive, by historical standards. When stocks become expensive, a correction typically follows. Corrections often require triggering events. COVID and Russia’s invasion of Ukraine certainly qualify.
From the beginning of the year, markets have reflected uncertainty about economic conditions, expressed by major indices falling well below recent highs. We are now in a period of decided, heightened volatility due to uncertainty about monetary policy, inflation, economic growth, and geopolitical risks. None of these concerns are as dire as COVID was to the global economy, but the investment environment has shifted significantly in the past few months. This has prompted us to make many adjustments to the investment assets in our care, to take a more conservative stance. What follows is an economic review of the current situation, which is not intended to discount the humanitarian and generally destabilizing impact of the situation in Ukraine.
The Past is Prologue
A PIM client mentioned recently that our newsletters tend to draw from past events and wondered how we apply those lessons to future investment management decisions. Historical investment returns are not a reliable indicator of future returns. However, historical risk is, indeed, a reasonably reliable indicator of future risk. Therefore, our perspectives about risk come from studying the outcomes of past events. Economics at the macro level is not a field where we can run experiments, changing one variable at a time until the desired data point is observed. Understanding risk, in an economic
framework, is a statistical exercise of disentangling the impact of individual factors from the whole to better understand what may come.
It should be noted that market corrections, triggered by geopolitical events such as the current Russia/Ukraine situation, tend to be short lived. There have been five such examples since 1964; Vietnam-Gulf of Tonkin Incident, The Gulf War, the Afghanistan War, The Iran War and The Crimean Crisis. The average duration of such periods involving physical conflict consists of three weeks to reach a bottom and another three weeks to recover to pre-crisis levels on average. The median fall in the S&P 500 during these periods has been 5.7%.
If one looks exclusively to the past for guidance, yesterday’s volatility appears to have been a strong “buy the dip” opportunity. The S&P 500 has fallen by more than 5% since the conflict escalated in mid-February, roughly matching historical averages.
Investors who only look to history as a guide will be rhetorically running to the sounds of cannons and buying equities, with the expectation of a strong rebound in the coming weeks. Perhaps this perspective makes sense. Russia is not well integrated into the global economy. Foreign investors have been reluctant to finance Russian capital markets for close to ten years due to political and legal disputes. It is not wise to invest in a country that is willing to completely disregard the rule of law based on the whims of an autocrat.
Russia accounts for ~4% of global GDP, and their leading exports are chemically enhanced Olympic athletes and a variety of natural resources, namely fossil fuels. The Russian and Ukrainian economies are not important markets for US exports, accounting for just over 1% of S&P 500 revenue. The US-based firm with the most to lose from further Russian sanctions is Phillip Morris, which derives 8% of its revenue from selling cigarettes to Russians.
For those that follow this line of thinking, Russia is neither an important destination of capital nor a key supplier of goods. This should limit the spillover effect from the collapse of Russian equities and bonds on other markets. OPEC nations, namely the Saudis, could be persuaded to increase oil production to offset losses from Russian sources, just as was the case during the Gulf War. This is a jaded viewpoint, but one not lacking historical parallels.
The S&P 500 is in correction territory and is down by more than 10% year-to-date. Of that decline, roughly 40% can be applied to geopolitical risk, though this is increasing daily. The remaining drivers of the decline are monetary policy broadly, inflation, and growth expectations. The Russian conflict is a key driver of the market decline, but it is not the only driver. The uncertainty surrounding future Federal Reserve actions and how they interact with other economic variables are a significant impetus for the current market correction. Monetary policy, the key driver of risk today, is likely to remain ambiguous at least until the next Fed meeting on March 16th. The guidance Chairman Powell provides at the press conference following the meeting will help set the tone for the markets moving forward.
In recent weeks, market strategists have been racing to raise their guidance for rate increases. Data suggests six quarter-point hikes over the next ten months, which would bring the benchmark short-term financing rate from roughly zero to 1.50%, with the goal of normalizing monetary policy and bringing down inflation. This scenario has always been likely to challenge the market, as higher interest rates increase the cost of debt (lowering profits) and lowers the current value of future cash flows (net present value of dividends and buy-backs). The secondary effects of the Russian conflict may serve to add additional complications to the situation.
The Impact of Conflict
Russia’s main contribution to the global economy is energy and grains. These two commodities have a heavy influence on headline inflation rates. This will impact how the Fed navigates monetary policy, even if their preferred inflation measures exclude food and energy. Twelve percent of global oil production is based in Russia. Crude oil prices have shown some signs of breaking higher but thus far remain fairly contained at ~$105 a barrel for Brent, the main benchmark for European oil. A move to $120-$140 would be consistent with previous conflicts. Banning Russian energy exports are the most significant sanctions currently under discussion. Such a move will impact the European economy heavily as 40% of their energy needs are met by Russian oil, gas, and coal. Europe’s energy consumption has declined in recent years, but their reliance on Russian sources has increased.
Russia and Ukraine collectively are forecasted to account for 17% of world grain exports for the 21/22 growing season. These two countries may not supply the world with high-value exports, but few can argue against the importance of food and energy supplies during a period of uncomfortable inflationary pressures. Higher food and energy prices serve as a tax on consumers, dampening growth.
Consumers are in the best financial position in forty years due to a wave of mortgage refinancing during COVID and a historically strong labor market. Corporate America is in a similar position. Earnings growth remains solid, if unspectacular relative to recent quarters. It’s a challenge, even if you squint, to find the type of economic imbalances that generally lead to lengthy recessions.
Geopolitical risk and monetary policy uncertainty are destabilizing factors, which can feed off each other. The only near certainty is that interest rates will move upwards. The chief spillover risk from the Russia/ Ukraine conflict seems to be increased inflationary pressures, just as Omicron begins to abate globally and supply chain stress eases. We’ve long held that inflation would be transitory because COVID did not structurally change the economy, but if you string along enough temporary setbacks, “transient” becomes a four-letter word.
Valuations, along with stated Fed policy intentions and lingering uncertainty about the details of future Fed actions led us to take a more conservative stance in our model allocations. Thankfully, this process was started several months ago. Depending on the model and custodian, all portfolios have experienced a degree of “de-risking”. Cash has been raised, the weight of the most volatile equities has been reduced, and more stable bonds have been purchased.
Every month, as we gather our thoughts and prepare this communication, we harbor a concern that by the time of publication, the information we present will be outdated. We can’t recall a time where that risk is greater than today. Conditions will change, perhaps rapidly in the days to come. The one constant upon which you may rely is our commitment to you, our valued clients. We will remain vigilant in our study of the investment landscape and will make decisions we believe to be in your best interests.