Has The Whole World Gone M.A.D.?
For more than 80 years, the most reliable deterrent against nuclear weapons was the fear that the retaliation would cause the annihilation of both sides. Many have described recent sanctions on Russia as the economic equivalent of the nuclear option. It begs the question, is the threat of economic Mutually Assured Destruction (M.A.D.) rising because of the war in Ukraine? We believe that the answer is no; however, the sanctions’ impact could still be significant.
Over the last several weeks, both policymakers and corporations have effectively isolated Russia to levels not seen since the collapse of the Soviet Union. Russian companies now find it increasingly difficult to sell goods other than natural gas and crude oil outside their borders. Likewise, it is difficult for Russians to obtain imported goods and services. Similar to the Soviet era, as Western companies have raced to exit the country, residents’ access to modern conveniences has been dramatically restricted. Levi’s jeans, Big Macs, and iPhones are now much harder to come by; hoarding stories are emerging.
While these may be modest inconveniences, we believe the outlook for the broader Russian economy is dire. Ratings on the country’s debt have plummeted to levels indicative of an imminent default, and economists widely anticipate a double-digit decline in GDP. Meanwhile, inflation is growing at a 20% rate, causing some observers to jokingly rename the Ruble to the “rubble.” Without a doubt, the weaponization of sanctions is proving to be a form of mass economic destruction.
There is also likely to be pain felt outside of Russia. Americans certainly feel the impact of higher oil prices at the gas pump. Russia accounts for 11% of the world’s crude oil production and nearly 25% of its natural gas production. While both OPEC and the U.S. can ramp up their production to fill some of the gaps, it is unlikely that they can entirely replace Russian supplies in the near term. In addition, the Russian war in Ukraine has the potential to disrupt agriculture markets as the two countries are significant producers of wheat, corn, and vegetable oils.
Source: Comtrade, World Bank
The conflict is coming at a sensitive time for the world’s economy. Global commerce was just beginning to get over COVID impacts that disrupted supply chains and caused a dramatic shift in spending from services to goods. Higher energy and food prices may slow growth as these non-discretionary items comprise a larger percentage of consumer and corporate spending. The World Bank estimates that a prolonged 10% rise in oil prices shaves about 0.1% from the economic growth of import-heavy developing economies. Over the last six months, oil has more than doubled, implying a 1% drag on these countries’ GDP.
From a secular perspective, the timing appears to be more advantageous. Developed economies require less energy to fuel economic production today than during the (first?) Cold War. Moreover, renewable energy may be a source of relief for consumers, as we highlighted here. Therefore, we believe that Russia’s ability to inflict a proportional amount of pain on these economies is limited.
More likely, both sides will use this as an opportunity to buttress their spheres of influence. Russia may be able to strengthen ties with countries like China by selling oil and natural gas at significantly reduced prices. Likewise, NATO members are increasing their spending on defense and energy independence.
Source: BP World Bank and BCA Research Calculations
We came into this year hopeful that COVID was no longer the most significant risk to the economy and investment markets. Instead, we suggested that it might be the potential for a Fed policy mistake. We believe that is still the case. The difficult task of normalizing interest rates and orchestrating a soft landing for the economy is much more complex due to the indirect effects of the Russian-Ukraine war. Just as the Fed could not solve COVID, we believe that they cannot fix inflation caused by supply-chain bottlenecks. Commodity price increases also, unfortunately, sit outside their purview.
For some investors, the last few weeks have been unnerving. Nevertheless, we believe that the long-term trajectory of equity markets remains positive. Last year, we began shifting some client portfolios to more inflation-sensitive assets like high-dividend equities and renewable infrastructure. We also allocated toward alternative strategies that may be less dependent on the direction of the equity or bond markets. While increasing cash or high-quality bonds may be tempting in this environment, we believe being overly cautious increases the chances of locking in losses after adjusting for inflation. This is due to our constructive long-term outlook for risk assets, the potential for the current crisis to resolve, and the possibility of continued hot inflation. We believe portfolios are well-positioned to mitigate present risks while keeping an eye out for tomorrow’s opportunities. As always, should we believe that investors are becoming overly fearful, we are prepared to act and, as such, have been busy updating our buy list.