From an email sent out to IIM investors on Feb 27th, 2022:
Good morning, IIM investors.
For long-term investors, periods of geopolitical risk are unavoidable.
This week’s events in Ukraine are troubling and evolving rapidly. A major world power invading a free sovereign nation is of enormous historical significance. And though I am skeptical of anyone’s ability to accurately predict what happens next – including my own – I do believe it’s now clear that an independent Ukraine is a significant threat to Putin’s power inside Russia.
On the surface, Putin began last week seeking to assert a claim to the Russian-controlled regions of Donetsk and Luhansk, with their forces finally entering the country after weeks of build-up and intelligence warnings. Like the 2014 annexation of the Crimean Peninsula by Russia, these moves clearly violate the sovereignty of Ukraine. The U.S., Europe and NATO allies have now responded with escalating sanctions and indirect military support, and Germany has also halted the Nord Stream 2 pipeline, which would carry Russian natural gas.
In reality, the true motivation for Russia goes beyond these two statelets and involves decades of tensions since the end of the Cold War.
The war in Ukraine is yet another geopolitical crisis intertwined with the business cycle. Others we have seen this century include the attacks on September 11, the war in Iraq, the Arab Spring, Russia’s annexation of Crimea, periodic North Korean missile crises, tensions between China and the U.S., the U.S.’s exit from Afghanistan last year, and many others. While each of these episodes is geopolitically impactful – especially when there are humanitarian consequences – that does not always mean there are implications for long-term portfolios.
While markets react to headlines on an hourly and daily basis, what drives investment value over years and decades is quite different. Over longer periods of time, steady economic growth, corporate performance, and valuations matter much more. This was true during those conflicts just mentioned – as well as in the decades following World War II and during the Cold War, when there were several long bull markets.
Some events such as 9/11 and the wars in Iraq and Afghanistan that followed were certainly met with market declines. However, these pullbacks coincided with the dot-com crash, which was entirely unrelated. Conversely, the various conflicts since the 2010’s – including multiple civil wars in the Middle East, Crimea, and the on-going nuclear threats in North Korea and Iran – were set against a backdrop of a strong economic cycle. Despite occasional short-term market uncertainty, the business cycle is ultimately what drove stock returns. The history of the 20th century across World War II, the Vietnam War, and the Cold War only further underscore this point. And today’s headlines are occurring during a strong economic expansion and just as the market is reacting to the Fed’s imminent interest rate liftoff.
Energy prices can be also affected by these conflicts, since they have tended to involve oil- and gas-producing regions. This is true today as well, with energy prices rising steadily as Brent crude approaches $100 per barrel. As a member of OPEC+, Russia is an important supplier of oil and natural gas to many parts of the world, notably Europe.
That said, energy prices had already been rising steadily throughout the pandemic recovery and in response to higher-than-expected demand. During the 2014 episode in Crimea, there was little direct impact on oil, and even the 2019 drone strikes against Saudi Aramco by Iran – which knocked out 5% of global oil production overnight – saw only a short-lived reaction in oil markets. The direction of energy prices in the short-term can be difficult to predict, to say the least.
The economy and cash flows are not the only factors that affect stock prices, however. Markets depend on global stability, the rule of law, and both business and consumer confidence. Regional conflicts that could involve the United States and its allies can increase the “risk premium” or “discount rate” in markets. Even if corporate profits and cash flows are unaffected, the possibility that they could be affected is enough to ding investor confidence and therefore stock prices. And that’s not an entirely irrational response – because if the world did destabilize, cash today would be worth much more than the promise of cash far out into the future.
However, history shows that it’s a mistake to make dramatic defensive shifts in investments in reaction to geopolitical crises. And it’s always the case that markets can swing wildly at any time – whether due to wars, economic shocks, financial crises, or pandemics.
The Russia-Ukraine war will increase the uncertainty of a market already trying to come to terms with tighter monetary policy. But in there may also be opportunity, too. Should this Ukraine crisis begin to metastasize into something more likely to impact the world economy, then it likely will show up first as higher oil and natural gas prices. Nonetheless, on balance, I believe the odds of this conflict growing to the point of triggering a global economic contraction are low. And if so, then it would follow that whatever degree of decline equities may experience would likely be short-lived. Like so many other times in the past. In the meantime, trying to calculate downside levels when markets are trading on emotion is guesswork at best.
None of this is to dismiss the severity of the current situation in Ukraine, from a geopolitical, humanitarian, or regional economic perspective. The challenge is to watch closely while staying objective and avoiding overreaction – because history has shown that investors ought to avoid passing judgment in their portfolios. Instead, these kinds of events should be considered in a broader economic and market context. Below are three charts that may help provide some perspective:
1. Geopolitical events can startle markets in the short run.
The history of geopolitics and the stock market is mixed. In the long run, markets tend to recover and perform well, primarily because business cycles are what matter over years and decades. In cases like 9/11 and the ensuing wars, markets were down because of bear market conditions already in place.
2. Oil prices have been climbing throughout the recovery.
Oil prices have been recovering steadily since they collapsed at the start of the pandemic. While regional conflicts can affect energy prices, history shows that this is neither guaranteed nor are there always long-lasting effects.
3. The stock market has grown despite a century of major conflicts.
The past century witnessed several major global conflicts including World War II, the Vietnam War, and the on-going tensions of the Cold War. Throughout these periods, the economy and stock market were able to grow steadily. For long-term investors, overreacting to these events would have been the wrong move.
The bottom line?
Geopolitical risk is unavoidable when investing over the long run. Nonetheless, investors should stay level-headed.
And perhaps remember the advice of the famously stoic Marcus Aurelius:
“Never let the future disturb you. You will meet it, if you have to, with the same weapons of reason which today arm you against the present.”
Please let me know if you have any questions. Thank you.