Russia invaded Ukraine this week in the largest European military action since World War Two. At this point, Putin’s goal looks to be overthrowing the democratically elected government and installing a puppet regime, like that which ruled the country before the 2014 Revolution. While Russia possesses vastly superior military forces, Ukraine appears to be putting up determined resistance. The 2003 US invasion of Iraq pitted the largest economy in the world, with a population of around 300 million, against a nation of 26 million ruled by an unpopular dictator. An insurgency against US forces did not develop until much later in the conflict. Nevertheless, the occupation proved painful and costly for US forces.
Russia, with a population of 146 million, invaded a country the size of Texas with a population of 44 million that appears to be galvanized around preserving its independence. There appears to be little public support from the Russian population for the war. The US and Europe responded by imposing relatively mild sanctions, stopping short of the embargo of Russian commodity exports and barring the country from the SWIFT financial system.
Russia’s invasion came during a sensitive time, with the global economy emerging from the pandemic and grappling with inflation and supply chain disruptions. Many segments of the equity market had declined prior to the invasion, as risk appetites for highly-valued technology companies waned. At the market close on February 24, the first full trading day after the invasion, the S&P 500 had a year-to-date return of -9.8% – with value stocks showing a smaller 6% decline while large cap growth was down over 14%. The YTD decline of the MSCI EAFE Index is about on par with the S&P 500, while the MSCI Emerging Market Index has a smaller decline which reflects the outperformance of China, which underperformed last year.
The invasion of Ukraine represents the largest European security crisis and most important test of NATO political will since the end of WW II. It adds momentum to the deglobalization trend that began slowly after the 2008 Global Financial Crisis, and accelerated with the election of Donald Trump and the COVID-19 pandemic. However, history shows that wars below the scale of the two world wars make little impact on the financial markets and global economy. No conflict since the end of the last world war has resulted in more than short-lived and relatively minor market declines, which would have made selling stocks during these periods a costly mistake. While an escalation of the conflict to the Baltic states (which, unlike Ukraine, are NATO members) is possible, and Putin’s ultimate intentions remain unknown, Russia will likely remain bogged down in Ukraine for some time, as they lack the former USSR’s capability to wage large-scale warfare on multiple fronts.
Barring further escalation to a global conflict, the primary risks to the global economy stem from the world’s dependence on Russian natural resources. In addition to supplying approximately 11% of global oil and 40% of Europe’s natural gas, the country is also the 6th largest producer of coal. Russia is among the top five producers of gold, platinum, silver, nickel, vanadium and sulfur. Ukraine exports agriculture, steel and, perhaps most importantly, 90% of the US semiconductor industry’s supply of neon. Ukrainian pipelines transmit a significant amount of Russian gas to Europe; although, new pipelines through Belarus reduced Russia’s dependence on this network. The reluctance of the Western Allies to impose more serious economic sanctions becomes understandable in this regard.
Our fourth quarter commentary identified three possible scenarios: 1) a tightening Fed may trigger a recession, 2) current inflation could prove to be transitory and stable economic growth resumes, or 3) inflation could remain stubbornly persistent, analogous to the 1970s. The invasion shifted risks further to the third option, the stagflation scenario, where inflation combines with slowing economic growth. Central banks will face difficult tradeoffs should inflation persist and economic growth begin to slow.
Placing meaningful sanctions on Putin’s regime will require policies that will cause economic pain and put further pressure on commodity prices. Higher quality businesses can weather these scenarios, but we will likely see waning demand for speculative investments as investors retrench in the face of greater uncertainty. Portfolios can weather any of the three potential outcomes above, but sustained inflation would be painful. Diversification and risk control remain critical. Owning quality companies and real assets purchased at reasonable valuations supports portfolios during periods of geopolitical and economic uncertainty. We have continued this quarter to review client cash flow requirements, and ensure adequate reserves are available to meet several years of distribution requirements.
— Stephen C. Browne, CFA
Chief Investment Officer
Chief Compliance Officer