Geopolitical Gyrations

Friday Reflection | February 18, 2022

The spectre of imminent conflict in Eastern Europe dominated the news this week. Equity markets declined as Russia amassed troops on the border of Ukraine and diplomatic efforts, while ongoing, have yet to yield a peaceful de-escalation. This heightened instability favors defensive assets including bonds and gold that can temper overall risk exposure. As investors nervously await the next headline, some are asking the question: what would the market impact be if an invasion actually happened?
 
We can never know exactly how the market will react, but looking at history we can see a fairly clear pattern. While potentially tragic for people living in the danger of a war zone, geopolitical shocks tend to have short-term impacts on global financial markets.

As investors look for historical instances of socio-political crisis from outright war to national protests on racial equity, there is no shortage of examples. Most are not perfect analogs for the current crisis in Ukraine, but they provide us with some reference on how markets price geopolitical risks and what lessons investors can learn from past periods of instability.
 
One of the more shocking crises in our recent collective memory was the terrorist attack on September 11, 2001, in New York City. Beyond the profound devastation of lost life, the attacks also caused investors to sell stocks out of fear and uncertainty about how the crisis could unfold and spread. The stock market declined over the next five days, with the Dow Jones Industrial Average ultimately falling -17.5%. Despite the unsettling decline, the market recovered quickly. By October 26, six weeks later, the Dow was trading higher than where it closed on September 10.[1] Looking back, the lesson for investors was, again, that staying invested and avoiding reactionary changes is usually the best strategy for long-term growth.
 
A similar pattern can be seen during other geopolitical or social-fabric shocks throughout recent history. Ned Davis Research conducted a study of 51 major geopolitical crises that includes events such as Pearl Harbor, the Cuban missile crisis, the Kennedy assassination, and the 9/11 terrorist attacks. Across all 51 crises, on average the market recovered all losses within six months. Within a year, the Dow Jones index was +6.3% higher on average. Price growth following a crisis is never guaranteed, but we want to highlight that sudden drops in the market due to crises are often disconnected from the financial fundamentals of the market.

What continues to matter most for the trajectory of stocks and bonds in 2022 is the path of Federal Reserve policy. While the historical data shows fleeting impact to market prices, the greater risk to financial markets from the current crisis in Ukraine are the dominoes that could lead to an acceleration of Fed rate hikes.
 
Higher interest rates generally pressure both stock and bond prices downward. If Russia invades Ukraine, and economic sanctions are imposed, that will further disrupt the supply of natural gas and oil that flows from Russia to Western Europe. If supply is disrupted, prices will be pushed higher. We’ve already seen oil prices steadily push toward $100 a barrel in recent weeks, reaching their highest levels since 2014. Natural gas prices have dropped from their recent highs a few weeks ago but remain at similarly elevated levels.
 
Higher energy prices are a direct input to inflation metrics, which could cause the Fed and the European Central Bank to raise rates more quickly than investors are expecting. Short-term price declines are a normal part of market calibration, as long as the combination of rising inflation and rising rates doesn’t erode consumer demand and tip the economy into a recession. There are many signs that the economic recovery is still going strong as pandemic impacts slowly abate, but this heightened risk has many investors paying closer attention.
 
For Europe, there is potential for longer-term stress regardless of the outcome in Ukraine as it is heavily dependent on Russia for commodities and energy supply. In 2020, nearly 44% of the EU’s gas imports came from Russia. For Germany, dependence on Russian gas is even higher – making up 75% of its imports.[2] Russia will always be the cheapest supplier with direct pipelines that avoid the high cost of shipping liquefied natural gas. The only way out of this risky dependence on Russia is the rapid expansion of renewable energy sources, similar to progress that Australia has made in recent years.[3] In the short-term, the current crisis could be a headwind for ESG portfolios as oil and gas companies see significant gains, but over the longer-term, this strengthens the growth case for renewable energy development.

Even though risks feel elevated in current headlines, the reality is that there are always risks, and opportunities, for financial markets. Current risks range from the Ukraine crisis to Fed policy and inflation to midterm elections later this year. We can also highlight a number of reasons for continued growth ranging from strong corporate earnings to a declining pandemic toll globally to the yet unknown advancements that will come from massive investments in scientific and biotech research over the past two years. Diversified portfolios are designed to balance these risks while maintaining exposure to equity growth that outpaces inflation.
 
With our clients, we focus on a clear strategy: take the appropriate amount of risk based on your situation, not based on market unknowns. When portfolio risk is properly calibrated to your life, then these moments of market volatility are less concerning. If you know you have enough liquidity, you can more easily ignore gyrations in the markets and alarmist headlines. When risk calibration and proper liquidity allow for it, the optimal strategy is to regularly rebalance your portfolio back to the intended target – incrementally trimming stable bonds and buying quality stocks at lower prices for long-term growth. When a destabilizing event happens – whether the current geopolitical crisis or the next one – we use history as a guide and, more often than not, we counsel sticking to the plan.

Resources

[1] This is what investment research suggests we do amid geopolitical crises MarketWatch

[2] EU imports of energy products – recent developments Eurostat

[3] Solar and wind have been the primary drivers in more than doubling renewable generation expansion over the last decade across Australia. Energy.gov.au