Sitting Around the Table
March 3, 2022
S&P 500 4,363
Crude Oil $109
Putin – Have you lost your mind or did you just miss-calculate?
The situation in the Ukraine has become a major dominating factor in the world’s financial markets. War has that effect on investors. What we are seeing now was unnecessary and at the same time completely predictable, and we are living with the sequence of a series of events, and it may go on and on with unintended consequences down the road that are much bigger than anything we can foresee today.
As an example Putin in rattling his saber is talking about potential nuclear events happening. He warned the West that “we will see consequences the likes of which we have never seen before.” Obviously that can only mean a nuclear event. Is he too young or simply uninformed to know the history of the Cuban Missile Crisis, which became the closest American has ever come to launching a nuclear war? So close that every year since 1962, the Pentagon puts together its best minds in different rooms, one set of people represents the US and the other set the Soviet Union. They then proceed to replay the Missile Crisis, and a strange thing happens.
In 60 years of doing this, the result is always nuclear war. This leads the thinkers to believe that it is so strange that only during the actual situation was peace achieved. In the war games, one side always launches.
This is because history always lies about the Cuban Crisis. History is always written by the victors and thus the bias is always on our side.
So the first question with the Missile Crisis is would Khrushchev have put those missiles into Cuba had Richard Nixon been elected and not JFK in 1960. The answer is NO. Khrushchev feared Nixon the Eisenhower disciple. You also notice that the Soviet Premier never tried to do anything while Ike was in office. No, he waited until Ike retired to Gettysburg and then went after JFK with a vengeance. He challenged him in Cuba during the Bay of Pigs, Laos, the Berlin Wall, the Missile Crisis, Viet Nam and on and on. He even challenged JFK at the Vienna Summit Meetings in June of 1961
berating the young President. As JFK walked out of the meeting with sweat pouring down his forehead, the patrician elder French President, Charles DE Gaulle, took the young JFK by the arm and said, “Mr. President, remember whatever happens, France will be with you, until the end.”
Now we are faced with another bully, only this time he has thousands of nuclear weapons at his fingertips. Not a good thing to have to confront, and thus he rattles the saber in a way considered unacceptable by normal international behavior codes. You don’t’ mention nuclear weapons, ever. It is an untouchable topic. He’s even brought up Hiroshima and Nagasaki in his statements. Putin clearly is not a good guy. So what does he want?
He is ashamed that the former Soviet Union has fallen to its current level in the eyes of the world. An empire no more with an irrelevant economy only good for selling its natural resources oil and gas to outside bidders because they can’t use them internally because nobody wants to buy their goods and services. His armies are outdated and still utilize World War II type thinking. Look at it yourself. He’s got a 40 mile supply line stuck for days on the road to Kiev. They are sitting ducks for any kind of NATO attack that would devour his forces in 60 minutes with hundreds of Javelin Missiles and other anti-tank and anti-armor weapons that we used for target practice. In the old days it was said that Russia’s armies were basically alcoholics and it was probably true then and remains at least to some extent true today. They are clearly not up to prime time.
But this invasion of Ukraine, IT CHANGES EVERYTHING. And that is what Putin doesn’t get yet and may not for a while. Think about it.
In launching an unprovoked attack on a sovereign European country and democracy, Russia is likely to face long-term diplomatic, trade, financial, and economic consequences. So long as Russia is governed by Vladimir Putin or individuals with motives akin to his, it will be ostracized and separated from the ability to engage in global markets for many goods and services, including most investment instruments.
The notion of the BRICs—Brazil, Russia, India, and China—as the secular drivers of global economic growth and investment returns long ago lost much of its cachet. Now, irrespective of the outlooks for the other three, Russia will be excluded from any such investment thesis. Russian government debt and significant chunks of its corporate debt and equity securities have become off-limits for global investors. That’s partly because of U.S. and European sanctions, but also because fiduciary considerations (“governance”) will not permit many institutional and private investors from considering Russian securities as eligible financial holdings. That fact will only change when Putin and his followers are no longer in power.
The Russian invasion of Ukraine will also lead to a significant rethink of global security, including energy security. Russia is the third-largest producer of oil in the world, the most important provider of natural gas to Western Europe, and a leading global supplier of other commodities. Ukraine is also one of the world’s three great breadbaskets, a major grain producer alongside North and South America. Assuming no quick resolution of the conflict, including a full withdrawal of Russian forces, buyers of energy and other natural resources from Russia and Ukraine will need to diversify their suppliers.
The clearest example is in Western Europe, where energy policy is likely to shift toward liquefied natural gas (LNG) delivered from North America, the Middle East, and Africa to reduce reliance on Russian pipeline supplies. Debates will grow about the need to rethink nuclear fission power and ultimately to explore the prospects for fusion. Wind, solar, and energy conservation will also take on renewed interest.
Investors, of course, also want near-term clarity and abhor uncertainty. Until such time as warfare is replaced by diplomacy, markets will remain vulnerable to bouts of volatility. Late last week, markets recovered sharply, mostly on the belief that sanctions will not have adverse impacts on global economic activity.
With Swift access being withdrawn and the Russian Central Bank’s ability to prop up its currency undermined, a range of difficult outcomes will ensue. The Russian economy will be hobbled, the ruble will go into free-fall as the exchange rate skyrockets, and there may be a run on Russia’s banks.
It should be investors’ baseline assumption that Russian energy exports will be disrupted, leading to higher prices for consumers and businesses everywhere. Moreover, if an act of war disrupted the flow of natural gas via Ukraine to Western Europe, price spikes would be compounded by distribution disruptions that could even risk European recession, with severe implications for U.S. exporters.
The jump in global oil prices related to the conflict is akin to an adverse global aggregate supply shock. It simultaneously increases inflation and damages growth.
That raises fundamental challenges for central banks.
Surging energy prices will compound already strong price increases in food, transportation, commodity, and industrial-goods markets, where energy is an essential input. It seems likely that other prices—those captured in core measures of inflation—will also follow higher. After all, the pandemic, global supply-chain disruptions, and accelerating demand have already unleashed strong increases in many wages and prices, which makes it easier to pass along higher energy and commodity prices.
Yet those same price increases are likely to outstrip wage gains. Now that U.S. consumers have drawn down savings to pre-pandemic levels, the risk is rising that flagging purchasing power could slow consumption. That concern is greatest in Western Europe, where households and businesses are also confronted by the greatest security threat since World War II.
So, will central banks choose to fight inflation more vigorously, or will they instead focus on potential challenges to global growth?
Recent comments by Fed officials indicate that an overwhelming majority of Federal Open Market Committee members remain undeterred in their assessment that monetary policy must be tightened to slow inflation. Apparently, it will require a significant adverse shock—for example, a much larger decline in world equity markets and a corresponding reduction in investment and consumer spending—for the Federal Reserve to change course.
The calculus for the European Central Bank is more problematic. Unlike an energy self-reliant U.S., Europe is dependent on Russian natural gas. The ECB must therefore be more attentive to potential weakness in consumer and business spending given uncertainty. It must also be prepared to respond to a massive supply shock in the event Russian energy supplies are disrupted.
The bottom line is that while the Fed is freer to focus on fighting inflation, the ECB must proceed with greater caution.
Still, both central banks share a common focus on inflation expectations. If already high inflation, now compounded by surging oil prices, results in a jump in long-term inflation expectations, both the Fed and ECB would tighten aggressively. Thankfully, that is not now the case. Market measures and surveys indicate that businesses, investors, and households continue to expect inflation to recede over time. But watch this space closely—few data points merit closer attention than inflation expectations.
All of which brings us to the investment implications of current events. History is kind to the idea that conflict-induced market selloffs are buying opportunities. In the terribly unfortunate language of Warren Buffett, investors should be prepared to buy when there is blood in the streets.
But we caution strongly against making decisions based on pithy statements. Even if, as we desperately hope, a cease-fire and peace can replace war in Ukraine, global equity market recoveries are apt to be brief and moderate. Here’s why.
First, market declines this year have been modest. A broad correction, defined as a 10% fall in major equity indices, has not yet occurred but is close if you measure from the peak.
Second, equity valuations remain above long-term averages despite clear signs of slowing earnings growth, high inflation, and a greater willingness by various central banks to tighten monetary policy. Historical comparisons, therefore, are naïve. Few of those oft-cited conflict episodes resemble today’s multifaceted investment challenges. Markets may rebound if the war in Ukraine comes to an end, but the bounce is likely to be unimpressive.
It is far more likely that risk-adjusted returns have peaked. Gains will be more modest and volatility higher. That outcome is probable irrespective of how events in Ukraine play out.
Finally, it is worth emphasizing that Russia’s invasion of Ukraine does not signal an end to global investing nor to emerging markets. Russia was never a major driver of globalization, whether in trade or finance. Its place in the BRICs acronym was always more out of convenience (BRIC’s sounds more solid than BICs). It was never fundamentally based. Asian and other dynamic emerging economies were always more important drivers of long-term global economic growth and investment returns. For most portfolios, the disappearance of Russia will hardly be felt.
So think about the preceding narrative in your investment considerations. Play our stocks and remember, NO MARGIN. You do not need that increased risk associated with MARGIN. Own your stocks for cash. We will have more to say shortly.
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