The headlines today are about Russia’s invasion into Ukraine. How does this impact our thinking about portfolios?
Earlier this month I was at a dinner with Ian Bremmer a political scientist and founder of Eurasia Group which bills itself as ” the world’s leading political risk research and consulting firm.” He dismissed the idea of a Russian invasion as have others despite repeated warnings from Washington. Northern Trust Asset Management issued a commentary on February 14, just 10 days ago, assigning a 10% probability of full invasion. The future is hard to predict and experts often get it wrong. Our approach is to build portfolios that produce successful outcomes for our clients across a wide range of possible geopolitical and economic outcomes rather than to maximize value in the one outcome we think most likely. This leads to diversification.
Let’s consider how markets have reacted to past geopolitical events. The Northern Trust commentary looks at 21 geopolitical events post 1940. They report that, on average, the market recovered in an average of 37 days (coincidentally, the longest recovery happened to be a Russian led event – the launch of Sputnik – which took 215 days). They observe “Historically geopolitical events do not impact financial markets for long unless the market outlook fundamentally changes.” That begs the question – What, if anything, has changed?
Until the Russia-Ukraine conflict captured the headlines, market anxiety was largely driven by rising inflation and how the Federal Reserve would respond. Now, sanctions against Russia will increase energy costs exacerbating inflation. There’s a difference between inflation created by rising demand (growth) and by a supply shock (Russia not selling its energy). The Fed can slow economic growth by raising borrowing costs which was the market’s outlook. Higher interest rates however do not increase the supply of energy. Higher energy costs caused by supply disruptions will also slow growth which may alter the Fed’s calculus.
Core to our practice is a belief that market prices for stocks and bonds reflect expectations for growth and inflation rates. Prices change as the unexpected occurs. By its nature the unexpected can’t be predicted. At any point we could have unexpected changes in growth and inflation expectations. We expect stocks to do better when growth and inflation are unexpectedly rising and bonds to fare better when they unexpectedly fall. Our approach is to have both in portfolios but to varying degrees based on risk tolerance and time horizon. The recent events do not change our approach but reinforces our view. We believe in patience and a cautious approach to current events.