Putin Reveals His Hand
Published on February 28th, 2022
Russian President Vladimir Putin finally revealed his hand and ordered the invasion of Ukraine. It is a full invasion with attacks beyond just breakaway regions in eastern Ukraine, with troops entering from Belarus as well as Russia and Crimea. The possibility of these events was suggested by prior Russian moves against Georgia and Crimea, the massive buildup of Russian forces in the prior two months, and recent U.S. intelligence disclosures. But Putin’s true intentions were not known until the invasion began. The U.S. and allied nations responded with economic and financial sanctions against Russia, which have escalated in recent days to include shutting off most Russian banks from the SWIFT global financial transactions network, a major escalation.
In response to Russia’s actions, over the past week the Russian stock market initially crashed by over 50% while the Russian Ruble lost about 8% of its value against the dollar. Given the dynamic nature of the still-developing situation, these levels are likely to change, perhaps dramatically, in the coming weeks. However, we believe the impacts of the conflict and associated sanctions on the U.S. capital markets are likely to be modest. Historically, most comparable Cold War and post-Cold War military conflicts have had little effect on U.S. markets. Looking to the closest analog, when Russia annexed Crimea in 2014 and the U.S. responded with sanctions, there was no discernible U.S. market impact, in our opinion. The 1998 Russian debt default catalyzed the collapse of Long-Term Capital Management, a large and levered hedge fund, prompting Federal Reserve intervention to stabilize the financial system. But U.S. banks are far more well capitalized today, making it very unlikely that any loss in value from Russian sovereign debt holdings would raise systemic risks.
In our view, one key feature of the current conflict stands out: It raises the risk of supply shocks across a wide range of commodities. This could come about by deliberate action from one or more of the parties who choose to limit their own supply, or to sabotage an adversary’s capability to reach the market. It could also result from miscalculation in the fog of war. While oil and gas are most closely watched, many metals, wheat, fertilizer, and uranium may also be vulnerable. In anticipation of the conflict, investors appear to have priced a geopolitical risk premium into many traded commodities. West Texas Intermediate crude is up nearly 40% in price since early December when satellite images displayed the start of a building presence of Russian troops near the Ukrainian border.
Upward pressure on commodity prices comes as U.S. inflation measures are accelerating to growth rates that are the highest in decades, and well above the Federal Reserve’s targeted level. We therefore expect the central bank will look through the limited impacts of the conflict on economic growth and persevere with its plans to raise interest rates at successive meetings throughout much of 2022,while simultaneously allowing many of its Treasury and mortgage-backed securities holdings to mature without reinvestment, thereby shrinking the size of its balance sheet. These actions will hope to fight inflation by tightening financial conditions but may also weigh on U.S. fixed income and equity markets. On the other hand, if the Federal Reserve sees any signs that the economy is slowing unexpectedly, it may have to pull back on its tightening activity. For now though, futures show that investors are expecting six rate hikes this year.
Looking ahead, we expect the assault to be short-lived. Either the parties will rapidly reach a negotiated solution, or Russia will overrun Ukraine with its superior military capability. But other scenarios are possible. We have been surprised that a few days after the invasion started, no Ukrainian city has fallen to the Russians, who clearly have a superior military in size and capabilities. And this horrible incident is complicated by the historical relationship between the two countries, with many families on each side of the border having relatives on the other side, which creates the potential for reluctance by Russian soldiers to aggressively attack civilian centers.
On the other hand, we believe the sanctions currently in place may well persist long past the end of the conflict, as will the geopolitical risk premium that investors have priced into commodity markets. Stepping back from these events, we believe the U.S. economy has shifted from early to mid-cycle. Investors now anticipate a far more rapid removal of accommodation than the Federal Reserve had forecast just two months ago. This pivot by the Federal Reserve to a potentially fast-paced rate hike path and runoff of its balance sheet has led to a surge in market volatility and a decline in investor sentiment and stock prices. The Russia-Ukraine conflict reinforces that negative sentiment.
We believe there is little risk of a U.S. recession at present, given the powerful momentum of the economy headed into this period, supported by record household net worth, the reopening tailwind, and the rebuilding of the inventory deficit. We continue to expect solid U.S. economic and corporate earnings growth this year. But the transition to mid-cycle, paired with a significant increase in inflation, has caused investors to revalue asset markets, a process we believe is underway but not yet complete. We raised cash in our equity portfolios in December and again in February, and in the near term we may continue holding excess cash to cushion the market’s volatility. As always, however, we will be looking for stocks which end up in the bargain bin if any market dislocations occur.