My F&M

Market Update: Bombs and Bonds

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Lenin said, “There are decades where nothing happens; and there are weeks where decades happen.”  The few weeks since Russia’s invasion of the smaller but fierce Ukraine seem to have much of that quality of compressed import. 

The world was not the same after WWI began.  It was not the same after WWII began.  It was not the same after the Cold War ended.  Some events suddenly make the world a different place.  After the invasion of Ukraine, it appears the Post-Cold War Era is over and prior norms will not revert as long as Putin controls Russia. 

We have observed this aggression with profound sadness – in sorrow, certainly, for the suffering yet inspiring Ukrainian people, but with more than that as well.  On some level, we each recognize and mourn the passing of an era – an era whose troubles now seem smaller from this current perch.

Our last comment was sent the day after the invasion.  Much since then has not gone as experts expected.  Some still think Putin may eventually win the war but lose the peace, mired in an intense insurgency.  Others expect a stalemate that becomes a “frozen conflict.”  However this plays out, many things in the past few weeks make this crisis unique:  thermobaric and cluster bombs have been used on civilians, multiple civilian healthcare facilities (including maternity hospitals), and a large nuclear power plant have been targeted.  Russia reportedly attempted to assassinate the Ukrainian president multiple times, and scores of captive Ukrainian civilians have been executed.  Putin declared economic sanctions “the equivalent of a declaration of war”, and, most significantly, he has threatened to use his nuclear weapons.

This is obviously not business as usual in super-power relations.  The Western democracies are suddenly in a new and antagonistic relationship with Russia.  At most turns, Putin has done little other than escalate.  If this results in a new Cold War, as looks likely, this changed world order may be the most important geopolitical shift since the early 1990s when the Cold War ended.

For its part, in arming Ukraine after the invasion rather than before, the West may have been insufficiently active in preventing this.  But it has been remarkably unified, forceful, and rapid in its response: the imposition of the most severe economic sanctions in the modern era coupled with NATO countries suddenly committing to a significant defense build-up while supplying Ukraine with needed supplies and weapons. 

Necessary as they were, the sanctions and other moves raise risks to economies and markets and generate more questions than answers.  We will all be trying to sort this out for some time.  But here are a few initial takes:

Risk may be greatest in Europe where European bank credit spreads have blown out and the price of Deutsche Bank stock, for example, was at one point down more than 42% from its level just prior to the invasion (though it has recovered to being down only about 20% as of this writing). 

We don’t know the answers to these, but here are some of the more relevant questions raised:

When financial markets “break,” it sometimes takes the form of a currency crisis followed by a debt crisis followed by an equity crisis that starts in one place and then spreads to others.  All three have happened now in Russia to a degree not experienced for many years.  Will Russia’s debt default?  Bank linkages, like credit default swaps, are hard to quantify in advance.  Markets have recovered substantially since the initial swoon, but risks remain.

The most potent of the economic sanctions was the seizing of dollar assets of the Russian Central Bank and cutting that bank off from the banking international settlement system.  That was vitally important to do but may carry a long-term cost to us as well.  How many central bankers in Asia, for example, will now view their dollar holdings as less secure than they formerly thought, and how many of their governments may seek to develop trade denominated in currencies other than the dollar?  If that occurs even at the margin, will that result in a weaker dollar, higher inflation here, and higher US interest rates in the long run than otherwise may have occurred?

Nine of the last eleven recessions have been preceded by sharp spikes in the price of oil.  US spending on oil, natural gas, and renewables is now about 11% of GDP.  The last time it spiked this much, it peaked at about 14% of GDP when it slowed the economy.  At what price does oil cause a recession now? 

Russia is the largest supplier of natural gas to Europe and was the third-largest exporter of crude oil.  Russia has been the world’s largest wheat exporter; Ukraine the fifth largest.  Ukraine has been the fourth-largest exporter of corn.  Russia was the largest exporter of fertilizers and a significant exporter of several important metals including nickel, cobalt, tungsten, and platinum.  How might supply restrictions of these impact the world economy?  Will Ukraine even have an exportable wheat crop or corn crop this year?  Will there be food shortages late this year and how much and how long will commodities prices fuel a spike in inflation?

China recently asserted it has a better claim to Taiwan than Russia does to Ukraine.  Will China seize this moment to seize Taiwan?

Significantly, these questions play out against the backdrop of the Federal Reserve starting its much-anticipated cycle of raising interest rates.  By itself, this would have been the most important event for financial markets in several years … except for COVID-19 – remember that?  Now, not only does Fed tightening coincide with the Ukraine war, but high inflation - the reason for the Fed’s tightening – is significantly exacerbated by the war.

The latest readings of US economic growth are strong.  Initial claims for unemployment just hit the lowest level since 1969, and unemployment just fell to 3.6%, nearly matching its pre-COVID low.  However, employment is a lagging indicator.  In other measures, inflation is soaring at multi-decade highs, the outlook for future inflation just went higher than at any time since 1981, mortgage rates are soaring, and consumer sentiment just fell to its lowest level since 2011. 

The “yield curve” is the difference between longer bond interest rates and short-term rates.  Lower long-term rates than short-term rates generally precede recessions.  There are various ways to measure this, but the most-watched just went negative, signaling an increase in the odds of a recession.

High energy prices, a negative yield curve, collapsing consumer confidence, and the Federal Reserve in tightening mode combine to raise the likelihood of a dip in the US economy within the next few quarters, though, of course, that is not certain.  Additionally, COVID-related supply chain challenges now combine with sanctions-related commodity shortages to raise the outlook for even higher inflation in ways that make it more likely to persist.

Together, risks and uncertainties on many levels are as high today as they have been for some time.  Additionally, but on a more minor note, markets will soon be entering the worst six months of the annual seasonal cycle as well as the worst six months of the four-year “presidential” cycle. 

Initially swooning over 12% after the invasion, the global benchmark for stocks closed the first quarter down only 5.4% for the year with international stocks and US stocks performing about the same.  Bonds are now down a bit more than stocks this year with the taxable bond index down 5.9%.  REITs are down about in line with stocks.  Growth stocks have generally underperformed value stocks this year after tracking closely last year.  

As long-term investors, we actively seek to avoid responding to market wiggles and fads.  But we have just witnessed some rapid changes that possess every indication of being long-lasting.  One is higher inflation for longer (especially in commodity prices), as has been noted.  Another is that the Western nations have suddenly embraced higher defense spending which is highly likely to persist for years.  Accordingly, where existing holdings and tax conditions allow, we are targeting greater exposure to still relatively cheap defense companies, as well as to fertilizer companies within stock holdings.  We want to add exposure to cybersecurity stocks, but companies primarily in that area have been too expensive to embrace so far.  We have slightly tilted more to inflation hedge assets, emphasizing commodity producers.  In bonds, we have adjusted emerging markets holdings to eliminate one ETF because it held 1.7% in Russian bonds. 

More broadly, we have always sought to build all-weather portfolios that can tolerate well the squalls that blow up periodically as well as the less frequent super-storms.  As such, there are not many shifts to portfolios we’ve found necessary to make.  Our bonds continue to be generally shorter in maturity than the bond market, our stocks tilt to better valuation, higher yield, and better financial strength than the stock market, and most of our portfolios continue to have meaningful allocations to market risk hedges and to real estate and other inflation hedges.  Portfolios so constructed are generally expected to tolerate challenging conditions better as so far this year they have.

Interest rates are a bit higher, which is good for future bond returns, but bond yields that begin with 2 remain meager while inflation begins with 7.  Similarly, future stock return prospects have somewhat improved as stock prices have come down just a bit, but only a little in the broader context of the doubling of the stock market that occurred since March two years ago, and stock valuations by nearly all measures remain exceptionally high. 

Courage, Churchill famously said, is the virtue that makes all other virtues possible.  We have many examples today of courage in the remarkable people and leaders of Ukraine.  Fortunately, those examples seem to have inspired our own leaders and those of Europe too.  America and the rest of NATO now appear to finally be done with appeasement.  This may be the most important point in the long run and the best reason to be confident the West will ultimately win in its struggle against authoritarianism. 

The near-term, however, may feature more surprises and setbacks as markets currently offer a scant margin of safety relative to near-term risks.