Russia’s invasion of Ukraine is a good reminder that geopolitical risk can swing markets dramatically in a short period of time. While it's difficult to ascertain how much destruction and civilian casualties will result from the conflict, we can safely assume global relations with Russia, an in particular within Europe, will be broken for some time, if not permanently. Let’s discuss the potential near term and long-term impacts for investments and what this event means for you.
In the near term, Western sanctions against Russia will target financial institutions and the energy and defense sectors. As of this writing, the G7 leaders have agreed to “devastating packages of sanctions”[1] to hold Russia accountable for its invasion of Ukraine. Some of these sanctions have been placed upon the company in charge of building Russia's Nord Stream 2 gas pipeline which was recently completed and runs from Russia to Germany.[2] Germany’s halting of the pipeline highlights one of the main near-term impacts of the invasion: higher energy prices. Oil supply has already been restricted because of the pandemic and any sanctions adversely impacting supply further, could easily result in higher prices.
We’re in an inflationary environment largely driven by restricted supply across various commodities and higher energy prices will only add to inflationary pressures. Global central banks are attempting to reign in inflation by raising interest rates. Most of the market capitulation this year has been a result of the market attempting to digest the impact of rising rates on risk assets. Instability in the equity markets could put pressure on central banks to raise rates more slowly. However, inflation is higher than we’ve seen in 40 years and central banks are committed to staving it off with higher rates.[3] Rate increases will likely continue (although perhaps at a slower pace) unless there is significant softening in the economy.[4] Suffice it to say the Fed has a fine line to walk. Below is a great graphic of the change in rate increase expectations over the past two days:
[5]Bonds, which traditionally provide ballast to portfolios when risk assets sell off, are a poor inflation hedge and tend to lose value when rates rise. Stocks and commodities provide growth and an inflation hedge but are incredibly volatile over short periods of time. This is an investors conundrum: the tradeoff of safety for inflation protection. A combination of all three: stocks, commodities and bonds is a good foundation for a diversified portfolio. For most investors, what is incredibly important today is liquidity. Having adequate cash reserves and conservative investments to spend during volatile times is critical. A secondary source of liquidity via a home equity line of credit or asset backed loan will also help by extending the timeframe to when you'll need to access risk assets.
Taking the long view, we can anticipate Russia’s actions will leave a lasting impression on Europe. In 2021, 38 percent of the natural gas used by the European Union came from Russia.[6] Russia has become an unreliable producer of fossil fuels and it’s likely we’ll see stronger investment in renewable energy as a result.[7]
It’s important to note most of us will own stocks in some fashion for the rest of our lives for reasons already noted. No matter your age or retirement status, it’s likely you won’t touch a portion of your portfolio for a very long time. The longer your time horizon, the more sense it makes to have an allocation to equities in your portfolio. Below is one of my favorite charts from J.P. Morgan which outlines variability in stock and bond returns over 1-, 5-, 10- and 20-year rolling time periods.
Simply stated, bonds are significantly less volatile over short periods of time and stock returns are generally positive over very long periods of time. As long as you have liquidity to weather a downturn, having an allocation to stocks makes sense. Having the right blend of stocks and bonds should afford you elements of growth, inflation protection, and safety. If we can embrace this long term perspective, then we don’t have to worry as much about the day-to-day movements of the stock market. Now wouldn’t that be nice?
I'll end this post with an anecdote. Whenever I travel and am getting ready to leave my family, I always remind my kids that daddy always comes back. The uncertainty children feel when their parents leave is in some ways analogous to an investor’s uncertainty with stock returns. Stocks lose value, but their value comes back too; we just need to ensure we have the resources to hold us over while we wait. Let’s hope this is a short trip!
[1] https://news.yahoo.com/biden-unveil-sanctions-russia-invades-175917247.html
[2] https://www.reuters.com/markets/europe/how-western-sanctions-will-target-russia-2022-02-24/
[3] https://finance.yahoo.com/news/fed-officials-signal-march-rate-173612552.html?fr=sycsrp_catchall
[4] https://finance.yahoo.com/news/fed-officials-signal-march-rate-173612552.html?fr=sycsrp_catchall
[5] https://www.morningstar.com/articles/1081251/5-charts-on-markets-response-to-the-ukraine-invasion
[6] https://www.nytimes.com/interactive/2022/02/15/business/energy-environment/russia-gas-europe-ukraine.html
[7] https://www.linkedin.com/pulse/financial-backdrop-ukraine-waits-worries-david-kelly/