Dear Clients and Other Friends,
We have been closely following the developments between Ukraine and Russia. Having spent time reflecting, I’d like to share some thoughts.
There are many lenses through which we can view and understand the war – politically, militarily, economically. But above all else, this is a humanitarian crisis. On a personal note, I am heartened at the unification and solidarity not just of our international allies (this war has aligned us and Europe with a decisiveness we rarely see) but also of companies and individual citizens. Some of the actions are more symbolic than economically influential (Russia and Ukraine combined account for less than 1% of US imports and exports1), but this doesn’t decrease their importance in signaling to Putin our strident and collective outrage.
For this particular note I set aside the humanitarian and political aspects of the war to focus on potential economic and market consequences.
Russia
The economic tools we and our allies have employed to attempt to halt the war are unprecedented and multi-faceted. We are choking off Russia’s resources and taking measures to seize up their financial systems. Russia depends heavily on energy exports, which many countries are no longer buying. Sooner or later, the heavy sanctions will cripple their economy. Whenever this war ends, if Russia moves further towards economic and political isolation, their long-term growth will likewise suffer. By most accounts this war took Russian citizens by surprise, and their country more than others will likely face the largest short- and long-term detriment to its economy.
USA and Europe
The US economy is much less dependent on Russian or Ukrainian trade than is Europe. We are the largest consumer of oil globally but also the largest producer; in total, only 7% of our oil imports come from Russia.2 Gas and other energy prices will go up, which will lead to higher inflation. On the positive side, due to COVID our household and company savings and balance sheets are strong, allowing us in the short run to absorb these increases (albeit unhappily). The Federal Reserve has stated its intention to raise interest rates next week (March 15/16) as a strong countermeasure against inflation, which had already been planned before the war began.
Europe is more dependent on Russia for oil and gas, commodities and agricultural products, which again pushes up prices across industries and leads to higher inflation. In the short run, Europe will use fiscal stimulus in an attempt to control inflation. Over a longer term I expect European companies to naturally decrease their reliance on Russian energy and goods, through increased domestic production, imports from other countries, or more efficient use of existing resources. Different sectors of the economy will experience different economic consequences – spending power is reduced in energy-consuming sectors but boosted in energy-producing ones.
Framing the Data
My main takeaway is this: For purposes of understanding the war’s potential effects, we must separate: (A) How the war may affect a country’s economy (i.e., global/country consequences) (B) From how it may affect earnings of public companies within this country (i.e., company-specific consequences) (C) From how it may affect index and stock prices within those countries (i.e., stock market consequences) I emphasize: these are not the same at all. There may be short-term correlation among A, B and C, but over time there is not.
Strong companies with competitive advantages can outperform in a slow economy.
Poorly-run companies can die in a strong economy.
Companies headquartered in slow economies may enjoy high profitability because they derive their revenue from customers in faster-growing nations.
Bottom line: It is the company in which we invest, and which may lead us to become richer or poorer, not the country. I don’t disagree with headlines stating that economic growth may slow in Europe and potentially the US. But there is much more subtlety in determining how this changes earnings expectations. I’ve created an example to illustrate the crucial nuance:
- Global: Economists estimate that the Ukraine war will cause global 2022 GDP to decline by 1%.3
- Country: Geographically narrowing this further, forecasts of 2022 UK growth have been decreased by 0.6%.4
- Index: The FTSE 100 (a subset of the London Stock Exchange) YTD has declined 6.9%.5
- Stock Price: And yet – Shell Oil PLC, a British company trading on the London Stock Exchange, YTD is up 7.8%.6
a.(As an aside, this is a holding of many European funds and indexes we hold in portfolios, including the American Funds EuroPacific fund.)
Summary
At the end of the day we are invested in public companies, which can and do move differently from country economies. My expectation is that markets in the short term will remain volatile, because uncertainty leads to emotional discomfort and elevated activity. The shock of war is a useful reminder of why we diversify not only amongst broad asset classes such as equities, real estate, bonds, and cash, but also amongst country domiciles, company sizes and industries.
The most effective way to mitigate the risk of unexpected events (including natural disasters, pandemics, wars and political instability) is through broad diversification, a flexible investment process, and structured financial planning.
Geopolitical risk is part of investing in global markets. Put into perspective, tensions tend to have a short-lived effect on markets. Sharp drops in the stock market are uncomfortable, but even given current declines we are still well within normal market movements.
Because financial planning and underlying investments incorporate ‘unexpected’ risks, we establish diversified, allocated portfolios up-front so that we are not forced to deviate from our strategy when these incidents inevitably occur.
Opportunities
As markets move, different types of opportunity are created. On a client-by-client basis I am reviewing financial plans over the next few weeks (concurrently with client tax-filing preparation) and assessing a number of applicable strategies, such as:
- Selective rotation of cash and bond assets into equity portfolios, to take advantage of price improvements/market declines.
- Taking losses in international funds to offset any significant embedded taxable portfolio gains in large-cap growth from the past year.
- Because the Build Back Better Act did not pass in 2021, I am also reviewing retirement accounts to determine where there may be both a short- and long-term tax saving advantage to converting a portion of Traditional IRAs to Roth. (Lower stock values mean lower taxable income tax payments now; sheltering savings in tax-free accounts means qualified tax-free withdrawals and tax diversification for the future.)
I am here if you would like to discuss any of these topics in more depth. In the meantime, I will be making adjustments to plans and portfolios if and as appropriate.
– Adrianne March 10, 2022
1Saphir, Ann, Marte, Jonnelle, and Dunsmuir, Lindsay. “How the Ukraine conflict could affect the U.S. economy.” Reuters, Feb 24, 2022
2U.S. Energy Information Administration, https://www.eia.gov/energyexplained/oil-and-petroleum-products/imports-and-exports.php. Canada is the largest single source of US total petroleum and crude oil imports. In 2020, Canada was the source of 52% of U.S. total gross petroleum imports, Mexico the second-largest source at 11% and Russia third at 7%.
3J.P. Morgan Global Research, “The Russia-Ukraine Crisis: What Does It Mean for Markets?” March 9, 2022
4BBC, https://www.bbc.com/news/business-60610537, March 4, 2022
5Per FTSE 100 stock exchange closing value, GBP, March 4, 2022
6Shell PLC [SHEL] common stock closing value, GBP, March 4, 2022