At the end of February 2022, Russia invaded Ukraine. Russia does not want The North Atlantic Treaty Organization (NATO) to expand east or to deploy strike weapons near the Russian border. So, Russia wants to take NATO’s military potential and Europe’s infrastructure back to the 1997 configuration, where Ukraine was part of Russia. And perhaps you could make the argument, that started back in 2014 when the Russians invaded Crimea and annexed Crimea.
We like to study history, see if there are any clues out there to help us with our forecast, but any military conflict is very unsettling politically and economically. The loss of life is tragic.
Today, we’re just focused on what it means to the economy and the financial markets. But throughout the past 40 years, these events—and there’s probably been about eight of them—really have not moved capital markets significantly, unless the U.S. and or the global economy falls into a recession.
Normally, these geopolitical crises ultimately turn out to be temporary disruptions for financial markets, and they can be a buying opportunity for long-term investors that are willing to look past the headlines. So, we’ve talked about this before. Every economic cycle out there has its own set of nuances, but at the same time, has similarities.
It’s the same with these military conflicts that we’ll share with you some case studies. But we don’t expect a recession in the next 24 months, so we are not making any material changes to our forecast.
We think that eventually cooler heads will prevail, and these disruptions will be temporary, similar to the historic events that we’re about to share with you. So, let’s talk a little bit about the economic impact. The U.S. represents about a quarter of global gross domestic product (GDP). Ukraine is only two-tenths of 1% of global GDP, and Russia is only 1.8% of global GDP.
The big drivers are the U.S., China and Japan. You could throw Europe in there, and then you get to these smaller contribution countries.
There’s one stat that I came across that I think really helps to put the size of GDP into perspective. You have California, Texas and New York, who all on an individual basis, have a larger GDP than the entire country of Russia. This is all without spending a dime on military expenses, which really is rather impressive. Now, if you wind it back to a national scale, the actual impact on the U.S. economy is expected to be limited. So, this is really because of the relatively small amount of bilateral trade between the U.S. and Russia.
Only about 0.3% of U.S. exports end up in Russia, and these are mostly things like machinery, aerospace and vehicles. On the flip side, Russia has only about 0.7% of our total imports, and we’re bringing in things like fuels, precious metals, iron and steel.
And while Russia is not one of the biggest players from a GDP perspective, they do have a far-reaching impact across global commodity markets. So, Russia is one of the world’s largest wheat exporters. They play a big part in industrial metals, and they’re essentially a gas station for a good portion of Europe.
They provide around 40% of all European gas consumption. And even if you look back to Ukraine, you know, in their own right, while only 0.2% of global GDP, they are still one of the world’s largest exports of grain, accounting for about 15% of global corn exports, and then another 10% of global wheat exports.
So, we’re not making the point that it’s insignificant, but when you put it in perspective, they’re not a major player, barring a few industries globally. But the implications for the U.S., clearly inflation in certain industries, the soft commodities, because Russia and Ukraine are significant exporters of corn and wheat, you’re going to see inflation there. That’s negative for the U.S. consumer, perhaps positive for the U.S. egg industry.
So, the risks would be escalation, if it continues to get worse and cooler heads don’t prevail, we might have to change our forecast, but history tells us right now, it would be temporary. And of course, there’s the risk of cyberattacks, which we’re starting to see around the world, where Russia has a bit of a history and resources there. But clearly, it’s a larger risk to Europe, as Russia provides around 35% of Europe’s natural gas, and 30% or so of oil to Europe.
But there’s larger risks to Europe than the U.S., but it does support our forecast of robust economic growth here in the U.S. For context, through the Cold War, Russia did not have a disruption in the supply of energy to the world. So, even with these sanctions, we’re going to turn off the spigot on energy products from Russia.
What history tells us
Let’s look at the annexation of Crimea back in 2014 when Russia invaded Ukraine, and you can see what happened.
Oil prices six months after the event started, was down 6%. There’s no Fed policy change. Globally, interest rates stayed where they were. But on the far right, look at GDP, again, using just Crimea as a case study. Global GDP for the G7 was up 50 basis points six months after the event started. It’s the most direct comparison to what’s currently taking place. You know, oil falling 5.9% after the annexation of Crimea, all those along with the current thought process that we have on oil prices.
But diving a little bit deeper into our oil forecast. And while oil has already crossed the $100 threshold, that is the first time it’s crossed that barrier in the last seven years, we don’t necessarily expect this to last long-term.
There is a possibility where if severe sanctions were to cut off Russian oil exports long term, we could still see oil prices temporarily rise further. But luckily, this is not the current expectation. So, while the situation does remain fluid, the consensus says that oil prices should gradually fall as we move through 2022.
And we might actually find relief from an unlikely source. Due to the crisis in Ukraine and Russia and the elevated price of oil, there are actually prospects for a nuclear agreement with Iran that are rising. Which means a million barrels of oil could come back onto the market, which would drastically help the prices and the supply and demand imbalance that we’re seeing.
History is on our side. History tells us that those energy prices will come down eventually.
Policy rates have changed because of world events. We anticipate the Fed will still raise rates because inflation is hot right now, but we’re in the camp that this might slow them down a little bit. They were talking about, maybe there’s going to be a 50-basis point hike this week from the Fed.
They’ll start out with 50 and then go on from there. But that would be a fairly aggressive move in the face of all this uncertainty that we’re facing right now. Global unrest, global uncertainty, war, probably not the right environment for them to come out with an aggressive stance right now.
We think it’ll slow down their urgency just a little bit, but they’ll stay on that path to four or five moves this year. If you get a natural pullback in activity because of all this uncertainty that’s in the news, if you actually see a little bit of a pullback in activity, then yes, it reduces their urgency to move. But we’re also going to see an uptick in inflation in the short run also. But in aggregate, everything that’s happening right now, should be helping them pull back a little bit and drop off their urgency to move aggressively and early.
The 10-year Treasury might be sending us a message, which today, the yield on the 10-year Treasury was 179 when I looked at it, clearly a risk-off trade in the markets. The 10-year was hanging around 1.95 or 2% coming into this whole thing. But whenever you have this much volatility, you have a spike of volatility in the stock market, you tend to trigger that risk-off thing that you’re talking about. We still think 10-year is going to work its way back up to two or 2.25 by the end of the year. And as we’ve been saying all along, none of that is bad news. They’re just making a natural normalization of rates. Those rates will still be totally supportive of a healthy economy, healthy markets.
Historically, the volatility has created buying opportunities. While we hope this is a short-lived event like Crimea, the volatility in stocks has created buying opportunities during these events.
One event which had potential severe consequences for the U.S., was the 1962 Cuban Missile Crisis, where we potentially would have had Russian missiles 90 miles off our coast. And it’s interesting because you have the same pattern with equity markets.
If you look at the S&P 500, you know that markets are volatile, and their start pricing in worst-case scenario. And for long-term investors, it pays to ride through volatility.
In regard to asset allocation, we have exposure to international markets, as well as emerging markets. The good news is we’ve been overweight domestic for years, which has been very fruitful for our clients. But we do have some emerging markets, and you can see the why. We’re not here to trade it, but why would we have it, and a trade we’re potentially exploring, maybe adding to it? The reason is, look at the returns that you see after some of these crises. So, it’s good to have some of these diversified asset classes in your portfolios, especially at times of high uncertainty.
The recent volatility due to the geopolitical events, is not the only reason that markets are selling off. So, in the short run, Ukraine-Russia is creating some volatility and compressing valuation.
The bigger risk of valuation really is longer-term, and it’s created – part of the sell-off is disinflation, higher interest rates. But one of the themes that we have right now is the current military events in Russia-Ukraine, are short-term volatility events, and they’re not earnings events, meaning the economic backdrop should not shift too dramatically.
Translate that into corporate earnings, which drive stocks. We’re not changing our corporate earnings forecast of 10% for the year. So, we still like stocks and we still think there’s upside, given those factors. In an accommodative interest rate environment, historical valuations can be in the 17 times to 20 times range. So, call it kind of where we are right now, maybe a little downside in the range.
The good news on the corrections is historically, this is going back to 1970, after corrections are over, S&P 500 is up 20%. So, that rhymes with our forecast of seven to 10% for the year based on historical data.
It will go up 18%. But no means there’ll be volatility all year, but it’s still – we’re not changing our forecast based on the economic backdrop. So, history is on your side that from January 1, if we see a 7%-10% appreciation for the calendar year, it’s about 18% or so from where we are today.
Energy is up 30% this year. Message for us is pretty simple is, it’s a sector we wouldn’t be chasing in here. We do own energy stocks in our portfolios. Fortunately, they’ve been really strong. But we remain in the trim camp on the energy sector because of crude oil during oil market disruptions.
The possibility of cyber warfare continues to grab headlines. And while growth names continue to see their valuations pressured from looming interest rate increases, the cybersecurity stocks have really seen strong performance during the current conflict. We’ve opted to hold a basket of cybersecurity names, and that’s really to better capture the overall theme in the market, instead of just riding with one name. It pays to be diversified right now. Keep in mind, we’re long-term investors. So, we are sticking with the forecast for the beginning of the year, returns in the domestic markets of 7%-10%. And history tells us if your risk appetite is appropriate and you have capital to deploy into risk-based assets, this is a good time.
The bond market is intuitive based on what we already talked about. We think the Fed is going to stay on their track. And we think the two-year is also going to stay in place. So, everything might drift up a little bit from where it is now, but it’s not going to be damaging to the markets in any way.
Even through all this crisis, the 10-year Treasury really has been kind of in a tight trading range. Before the crisis, there was a lot of mystery around, why wasn’t the 10-year moving higher with all the inflation that’s out there? It was stuck around 2%. And now, with the crisis, it has moved down a little bit, but it’s been in a pretty darn tight range.
And with modest inflation, modest reaction from the Fed and modest economic growth, we think this is appropriate from the 10-year, at least that’s what we think it is telling us.
Additional media coverage on the economic impact of the Russian invasion of Ukraine can be found at the Business Journals‡.
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