The Brave Report: The Crisis in Ukraine

Click here for the .pdf version of this report: The Brave Report-Crisis in Ukraine

So far this year, the main driving force behind the market has been uncertainty around how the Fed will keep inflation under control without slowing the economy too much.  That all changed when Putin decided to invade Ukraine. So, in lieu of my normal commentary I wanted to put out some notes on the impact of the Ukrainian crisis and what we can expect as the situation plays out.  It is important to differentiate the human vs. economic impacts this invasion is causing.  We can all agree that the human toll of this invasion is terrible and is only showing signs of getting worse before it gets better.  The major worry is that as Putin becomes more frustrated with the lack of military progress, he will get more and more brutal on innocent civilians. With that said, my job is to understand the economic and investment impacts of this crisis.

So how will this situation play out moving forward and how should you weather the storm? I see 3 potential scenarios playing out over the next few months:

  1. Occupation: This is the most likely scenario we will see. Under this scenario, we see a long-drawn-out occupation of Ukraine by Russian forces.  This could entail complete occupation of the capital and all outlying areas or some sort of partitioning where Russia controls large swaths of Ukraine but doesn’t fully topple the government.  NATO nations are reluctant to get involved beyond providing humanitarian support and small defensive arms.  The Ukrainian resistance consists of traditional military operations as well as insurgency attacks that carry on for a long time.  Under this scenario, no one really wins but the Ukrainian people are the real losers.  Putin’s pride keeps him engaged in the conflict well past any real gain can be had. Economically, we see energy and commodity prices remain high until some alternative source can be secured.  Global growth slows, especially in eastern Europe.  I don’t see the US slowing enough to cause a recession but those countries with high reliance on Russian energy will see a major slow down.
  2. Escalated War: This is the worst-case scenario. Either Putin gets frustrated by a lack of progress and escalates the war to a point where NATO must get involved or he becomes emboldened by success in Ukraine and overreaches into a NATO territory. In this scenario, we see a full military conflict between US/NATO and Russia, the level of which would be the big unknown but brings in several really bad outcomes. Again, the US would be the most protected due to distance but with Russia’s military capability, nuclear arsenal, and desperate leader anything is on the table.  The economic fallout would probably be the least of our worries but if this tail risk scenario looks more plausible, we would see a massive rush toward safety and a huge de-risking of assets.
  3. Ceasefire and Withdrawal: This is the best-case scenario for all involved but also very unlikely due to Putin’s empowerment at this point.  In this scenario, some sort of peace deal is reached, and Russian forces withdraw back to Russia. They may gain a little land in Eastern Ukraine as part of any deal and Ukraine may need to concede to never join NATO but democracy is restored to Ukraine.  For any deal like this to be achieved, China would need to ramp up pressure on Putin and/or there would need to be some discontent within the Russian military and among Russian elites.  With all the sanctions in place, there will be quite a bit of suffering within Russia.  The questions are, will it matter to Putin, and will China be able to exert enough pressure on Putin to force him to withdraw in a way that he can still claim some sort of victory?

Investing Through the Storm

With all the unknowns around this conflict, what is the economic impact and how do we invest through this storm?  First and foremost, volatility is going to be the norm for the coming weeks and months. As the conflict unfolds and the Fed starts raising rates, I expect wide daily swings throughout the equity landscape as news around this crisis continues to drop.  We have already seen a correction in equities that is in line with the average correction, going back to 1929.  Many areas of the market have corrected much more than average and I expect this volatility to continue.

There are some silver linings to this volatility.  Due to earnings results that exceeded expectations in Q4 and the correction we have seen so far this year, valuations have come back closer to long-term averages.  To start the year, the PE ratio on the S&P was pushing up toward 23.  It now sits just under 19 which is in line with the average PE over the last 5 years.  It is still slightly above the longer-term average but is not nearly as stretched as it was to start the year.

Outside of inflation, other economic data has been coming in strong.  Employment and wage data remain strong, the pandemic seems to be waning and the Fed has all but confirmed a 0.25% rate increase this month so some of that uncertainty has been diminished.  This strong economic data gives the US economy a much larger cushion to withstand some of the shocks from the conflict in Ukraine especially because our economy has such little exposure to Russia and Ukraine. This means headline risk will be driving the majority of the market moves and not actual fundamental risk.

I am not saying the conflict won’t have any fundamental impact on our economy and our domestic companies. Obviously, any companies that have revenue exposure to Russia and Ukraine will see a hit to their sales numbers as they stop doing business there or are prevented from doing business there.  Other than that, the major economic impact will be felt from rising input prices, such as transportation and commodities.  Oil prices have doubled since last year and this will have a negative impact on those companies that aren’t able to pass this increase on to consumers.  Other commodity inputs have also risen, and this will keep continued upward pressure on inflation.

The overall slowing of the global economy will also put some pressure on the more economically sensitive sectors.  At some point, rising prices will force consumers to cut back on certain amounts of discretionary spending and this will have an impact on earnings results over the next few quarters. However, with the strength of the labor market and wages, this impact should be muted in the US.

If you are a long-term investor and have no short-term liquidity needs this is a time that you need to just ride out the storm.  There may still be pain ahead but trying to time the market during these types of environments is near impossible unless you are a seasoned day trader.  If you do have short-term liquidity needs, raising cash on any strength, or implementing some hedging strategies would be advised so you are not forced into selling when you don’t want to. If you are worried about the worst-case scenarios then adding some tail risks hedges would be appropriate, albeit this type of protection is very expensive right now.

If you do have cash on the sideline to put to work, I would stress the need for patience.  I do think this volatility has created some great opportunities for the long-term investor and there are a number of great companies trading at huge discounts. However, during times of volatility and geo-political conflict, the importance of valuation is often diminished.  The old saying goes, “Don’t fight the tape.”  If the whole market is de-risking, even undervalued companies will be sold. Use this time to create a buy list of companies that are trading well below their long-term average valuations and who have little exposure to Russia. Slowly add to these positions on weakness. This volatility will persist for a while so there is no need to rush out and buy all at once.