Unpacking the Russia/Ukraine Conflict
At weeks end, tensions were high, and uncertainty remained around a potential Russian invasion of Ukraine. The lack of clarity has added volatility to the market as investors grappled with the ambiguity around how to best position portfolios given the conflict. Markets reacted negatively with the S&P 500 concluding the week -1.5% lower. A risk-off tone emanated through the market as safe haven assets such as gold (+2.1%) rallied. As nominal rates on Treasury bonds have risen considerably thus far in 2022, we saw Treasuries return to form as flight to safety asset with yields backing off, and prices rising, during the back half of the week.
We see the most relevant economic challenges stemming from any conflict being higher commodity prices and added supply chain bottlenecks. Both could serve as constraints on economic activity throughout the European continent. Russia produces roughly 11 million barrels of oil a day, or about 10% of global supply. An even greater impact is natural gas, as Russia supplies 40% of Europe’s natural gas. Ukraine, known as Europe’s breadbasket, is resource rich and in particular a significant supplier of corn and wheat. Energy and agriculture are largely local commodities, and such a gas or grain shortage in Europe will not directly impact the U.S. However, a conflict could lead to a redistribution of the supply chains as these commodities are sold and procured elsewhere. Regardless of how commodity consumption is impacted, inflationary pressures are only likely to rise under such circumstances.
As we have analyzed previous military conflicts, they have typically resulted in brief downturns in the market, with returns often falling in advance of the conflict. We believe we are seeing this in the market today as rising uncertainty around the size and impact of any conflict are resulting in an economic growth scare. At this point, it’s hard to say what needs to be priced into stocks, particularly U.S. equities. Fundamentally it would seem that European and emerging market equities may have more underlying risk inherent within them. A layer of ambiguity on top of direct economic consequences is to what extent sanctions might be applied and any secondary impact they may have beyond Russia should a conflict arise.
This assessment returns us back to the Federal Reserve. This past week, Chicago Fed President Charles Evans, a long-time dove, came out and indicated the Fed needed to be more aggressive in responding to higher inflation. Any additional supply/demand pressures stemming from geopolitical tensions are only likely to add to inflationary concerns for the global economy. These pressures could lead the Fed to tighten more aggressively and hence be less able to act to support the market in a period of uncertainty. Over the past decade markets counted on the notion of the ‘Fed put’, which was the view that if market conditions got rocky, the Fed would ease policy to support the market. In our view, the Fed is forced to focus on fighting the fire of inflation and is going to have to let other impacts smolder.
We continue to have conviction in our long-term return expectations and remain comfortable wading through any near-term volatility due to tensions between Russia and Ukraine. While we wish that markets only went up, we acknowledge that the current geopolitical conflict is likely to be headwind for markets over the near-term. As some investors elect to make top-down shifts in their portfolios as they react to changing market conditions, we expect these shifts could result in some mispricing of assets, and ultimately opportunities for patient, long-term investors.
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