Special Market Update

March 8, 2022

Long-term Implications of Russia’s Invasion of Ukraine

What’s Important

• We think the COVID context is a useful way to consider the longer-term implications of the Ukraine invasion. We believe investors should shift their views from expecting a “return to normal” toward diversifying portfolios to include commodities and real estate.

• We do not expect Putin’s irredentist views to change and, as a result, expect months if not years before a resolution.

• We expect a period of reactive policy actions, many of which we expect to become permanent over time. For example, U.S. Congressional leadership reached a bipartisan agreement last evening on a legislative package that will ban energy imports from Russia and revoke Permanent Normal Trade Relations for Russia as well as Belarus.

• Oil and gas exports are crucial to Russia: In 2021, they accounted for 21% of Russia’s GDP and half of total goods exports.

• We reinitiate a “stay-at-home” view and favor U.S. assets, given a very high probability Europe will go into a recession in 2022 and longer-term consequences will remain challenging.

Lessons from COVID

Back in the spring of 2020 when COVID began hitting the U.S., many thought that it would be over in a few weeks. Over two years later, the lessons investors should have learned are that 1) there are always unintended consequences and 2) hope is a terrible investment strategy. We think the COVID context is a useful way to consider the longer-term implications of the Ukraine invasion. We believe investors should shift their views from expecting a “return to normal” toward diversifying portfolios to include commodities and real estate. We do not expect Putin’s irredentist views to change and, as a result, expect months if not years before a resolution. Nonetheless, one thing is becoming much clearer with each passing day: in the words of Ian Bremmer at Eurasia Group, “the peace dividend is over.”

Policy changes are underway

We expect a period of reactive policy actions, many of which we expect to become permanent over time. For example, U.S. Congressional leadership reached a bipartisan agreement last evening on a legislative package that will ban energy imports from Russia and revoke Permanent Normal Trade Relations for Russia as well as Belarus. According to the Energy Information Administration (EIA) in December 2021, 5% of oil and refined product imports were from Russia. While the economic and market impact to the U.S. from these actions will likely be small, the scale and timing of sanctions from Europe and other world nations will exaggerate the effects. Russia is now the most sanctioned country in the world — and we would expect the ban on Russian energy imports to last as long as Russia still has troops in Ukraine. The global policy shift to remove a major world energy supplier on an intermediate- or long-term basis is game changing.

Our views on the consequences of the invasion and of banning Russian energy

• Inflation will remain high in developed markets: potentially hitting over 8% the next few months in the U.S. and likely ending 2022 in the 5% range.
• Higher fuel prices over 2022–2023 will cost households hundreds of billions of dollars, leaving them less to spend on other goods and services. Higher natural gas prices will have similar effects, but will be more pronounced in Europe.
• The impact to demand will be much more significant in Europe than in the U.S. due to wholesale energy prices rising further in Europe and Europe’s supply chain being more exposed to Russia. The net impact could move Europe into a recession in 2022.
• Inflation expectations going forward will be higher due to higher energy and input prices. This will impact global central banks’ calculations regarding how and when they will remove their longstanding accommodative policies.
• Higher energy input prices will translate into a myriad of higher prices in other areas, including food prices as fertilizer and processing costs rise.
• Russia and Ukraine’s combined supply comprises approximately 30% of global wheat supply. However, the U.S. doesn’t import much of our wheat from either country. Russian and Ukrainian wheat primarily supplies Egypt, Turkey and Indonesia.
• Historically, since non-energy commodity prices haven’t had a strong transmission mechanism to consumer prices in developed markets, we expect uneven inflationary impacts across income strata with the lowest income feeling the biggest inflation bites.
• Increased military spending among NATO’s EU states will increase demand for oil, steel and industrial metals. This will stress already-tight inventories.
• Aside from a token release of oil from the Strategic Petroleum Reserve, currently there has been no policy response from the U.S. government to support consumers. We expect that most governments will embark on policy decisions that may cushion the blow to households.

Potential consequences to Russia

• Oil and gas exports are crucial to Russia: In 2021, they accounted for 21% of Russia’s GDP and half of total goods exports.
• If the world decides to stop buying ALL Russian oil and gas, it would have a catastrophic impact to its economy. A severe decline in Russia’s export income would lead to a strain on balance of payments, cause a steep contraction in domestic demand to reduce imports. There would also be huge job losses, rampant inflation and a significant depreciation of the ruble.
• A reduction in export revenues could lead to Russian corporates defaulting on external and domestic debt.

What we expect in financial markets and portfolio strategy

• Long-term earnings-per-share (EPS) expectations will likely be adjusted downward with higher input costs.
• With no peace dividend, there could be a higher equity risk premium (and lower valuation multiples), and investor sentiment on international equities could remain depressed.
• We do not believe recent weakness in the equity markets is an opportunity to rebalance portfolios yet as there is still significant policy risk.
• We reinitiate a “stay-at-home” view and favor U.S. assets, given a very high probability Europe will go into a recession in 2022 and longer-term consequences will remain challenging.
• Market volatility will persist, so this is a time to favor active management; we do not recommend an indexed-based approach in a highly bifurcated market.
• Commodity prices are likely to remain elevated, and we would add commodities to portfolios, funded from the equity allocation.

Going forward

The situation in Ukraine is very fluid and changes by the minute. The Russian invasion of Ukraine is not likely to be resolved anytime soon. In fact, we think it could drag out for months if not years. This heightened geopolitical risk will translate into market volatility since this raises uncertainty — and markets do not like uncertainty. Despite the geopolitical risks, it makes sense to stay constructive on equities in the medium term. We favor U.S. assets going forward.