There is no more guessing about Russia’s intent; they have invaded Ukraine.

There is no more guessing about Russia’s intent; they have invaded Ukraine.  This is causing ripple effects throughout the global economy.

Markets despise uncertainty. Equity markets down, bond prices up, commodity prices up.  Equity markets up, bond prices down, commodity prices down.  All of the day-to-day prices movement is based on the extrapolation of short-term data into a long-term view.  The accuracy of long-term views at the start of a conflict are going to be seriously flawed, especially in an era of rapid, although not necessarily accurate information.

Change in Brent Crude & Natural Gas Priced YTD

Here is what we do know.  First, the largest impact on the global economy from this conflict is the price of oil and gas.  We have already seen a rapid rise in the price of oil (see chart). How will this impact the global economy?  Overall economic prices will continue to rise.  This is nothing new, as we were already seeing a US CPI print that was well over the 2% Fed target, clocking in around the 7% level.  Higher oil and gas prices will exacerbate this increase, having the net effect of slowing down demand.

While this is never fun, the markets had already expected the Federal Reserve to “take away the punch bowl” by raising interest rates in the years ahead.   The rapid rise in energy prices will have dual effects.  It will slow down global growth with rising input costs and cause global governments to rethink their energy policies.  The first we prepared for, the second is inherently unknowable.  While most governments are looking to transition to renewable energy, the supply of it is not enough to handle the current demand.  What will be the response to this imbalance?  Should the United States trade one bad actor (Russia) for another (Iran) to provide the oil that we need?  How long and how much can the global economy handle price increases until the economy stops?  The globe is about to start a game of chicken with energy prices unless serious consideration is made to creating more, albeit less “green” in the short-term.

Is this catastrophic for markets?  In a word, no. Markets are merely a pricing mechanism.  If energy prices continue to rise, suppliers and manufacturers will raise their prices to cover their new input costs.  This will ripple throughout all economies.  We had already expected this, but not to the degree that we now see. Wages will not keep up with the new pricing in the short run; but may be adjusted in the longer run. GDP growth will slow down if new energy supply is not brought online.

In addition, Russia and Ukraine are not very big players in the global markets. While this conflict is atrocious on a human level, the impact on any other industry other than oil and gas will be nominal.

Portfolio Positioning

Market Return YTD

In times like this, diversification does provide quite a bit of risk mitigation.  As I mentioned earlier, as equities go down, bonds go up, and commodities go up.  When risk starts to subside, the reverse will occur.  We hold positions in all of these asset classes.  We have positions that are doing well (commodities and bonds) and those that are not doing as well (international).

This year, we have made some changes in some of our fixed income positions to shorten up our portfolio duration.  We continue to believe that rising interest rates will be the major impact on bond prices moving forward.  We also believe that the current big swings in the market that we are currently seeing, will generally disappear the longer the conflict goes on.  Rebalancing portfolios in this context will certainly have added value as we move through these market swings.  This involves selling the best performing asset class and buying the worst performing asset class.  This forces us to sell high and buy low.  Keep an eye out for these trades as markets reprice.

This conflict will be resolved eventually. I hope that our world leaders will come from a position of strength knowing that this situation is rapidly becoming one against the globe. Even if the Russians win, they ultimately lose on the world stage.  Literally the only negotiating position they have left is their supply of oil and gas.

From a historical perspective, geopolitical events have a 1 – 2 month impact on the equity markets and disappear by month 6 and by month 12 are almost completely forgotten.  I don’t think the energy supply will be solved in that time frame, but it is likely the conflict will.

As always, please do not hesitate to reach out if you should have any questions.

Sean