Assessing the Russia/Ukraine “Black Swan”

March 5, 2022 | by V. Henry Astarjian | Posted in Blog

“Black swan” is a term often used to describe a situation with significant consequences that could not have been predicted, but that occurred nevertheless. With this month’s conflict in Ukraine, we now have a geopolitical black swan of significant proportions and deep implications for the world.

In addition to the unnecessary and profound human suffering we are witnessing in this latest war on the European continent, we are also seeing a seismic shift in the world order, all in the blink of an eye. Russia’s apparent decision to bring former Soviet regions back into the Russian fold, and Germany’s decision to re-arm are just two of the most noteworthy changes from the status quo of the past 70+ years.

No doubt historians and political analysts will have much to say about the current situation, and the potential new order. We are already hearing predictions from many corners.

For serious long-term investors, staying objective and considering how to best invest in this new environment can be a difficult, yet important task. As always, perspective and a rational assessment are helpful, so let us apply those here.

Despite being geographically about the size of the United States and Canada combined, Russia is only a minor trading partner of ours. According to the Office of the United States Trade Representative, in 2019 just before the Covid-19 pandemic took hold, Russia was our 26th largest trading partner with annual two way trade of only $28 billion. That includes $5.8 billion in our exports to Russia and $22.3 billion of their exports to us. Their largest export to the U.S. was fossil fuels at $13 billion, followed by precious metals and stones at $2.2 billion, iron and steel at $1.4 billion, fertilizers at $963 million, and inorganic chemicals at $763 million. For the U.S., Russia is only a source of commoditized natural and fabricated resources. 

In terms of direct foreign investments, U.S companies invested only $14 billion into Russia while Russia invested a mere $4.4 billion into the U.S. By comparison, the Netherlands which has only 12% of Russia’s population and is a tiny 0.3% of Russia’s geographic size, invested somewhere in the range of $840 billion into the U.S. during the same period.

Ukraine is an even smaller trading partner of ours, accounting for only $3.7 billion in exports to the U.S. in 2019, mostly in commodities. That makes Ukraine our 67th largest trading partner. By comparison, our three largest trading partners, China, Canada, and Mexico, each accounted for more than $500 billion in annual trade.

In other words, for the United States neither Russia nor Ukraine are significant in terms of our imports or exports. Their loss as trading partners should have only minimal effect on our supplies of raw materials, and on American corporate earnings.

The more important immediate significance of this war to business and investments is its wider effects on the global economy, inflation, and interest rates.

Global trade and economic activity, may be significantly affected as air, ground, and sea routes around and through Russia and Ukraine are closed or otherwise restricted. Cargo planes will have to take longer and more costly routes from points of production in regions such as China and south Asia, to markets on distant continents, and vice versa. Passenger flights will have to make similar route changes, possibly costing airlines more in fuel and time. Grain transport out of Ukraine and Russia may also be constrained, adding to grain shortages worldwide. 

Global trade could also be constrained by Russia’s inability to use the SWIFT banking system to send and receive secure monetary transactions. And foreign workers in Russia may have difficulty sending remittences back to their home countries – these countries too will be affected and will add to global economic difficulties.

Constrained oil and gas supplies from Russia means that energy inflation could rise even further than it already has, unless other oil producing nations increase production. As a reminder, overall energy prices spiked higher by about 30% in 2021 because of the decreased production of fossil fuels in 2020 as a result of sharply weaker global demand during the Covid-19 pandemic. With most of the developed world having started to recover over the past year, higher oil and natural gas prices from this new conflict will be an even further threat to economic recovery. 

Further, the tide of rising inflation, combined with the prospect of a slowing economy might make it harder for central banks, including the U.S. Federal Reserve, to raise interest rates quickly and aggressively to fight inflation without harming the economy. The Fed may have no choice but to make only minor interest rate hikes this time around. In other words, we may be facing a situation where the economy slows, but inflation remains higher than desirable. Over the past three years, inflation has come primarily from shortages caused by a combination of trade tariffs and Covid-19 on the one hand, and government money printing on the other.

At a time when the world seems to be changing rapidly, and with so much uncertainty circulating around, how should we invest? 

My baseline assumptions for this year are that 1) the Fed will raise interest rates by some amount to reduce inflation, 2) the economy will slow, 3) corporate earnings growth will slow by comparison to 2021, and 4) equity valuations will continue to trend lower, approaching more historical levels. We are already seeing some of this.

Across the board, many individual stocks have already corrected or are in the process of correcting as a result of slowing earnings growth. Meta Platforms (FB) may be the most prominent example of this recently where the company had to ratchet down their earnings expectations, resulting in a 26% drop in the share price in one day. 

Last year the component companies of the S&P 500 Index saw their earnings grow by almost 31%. The 5-year average is 13%. Wall Street analysts are now predicting that earnings for those same companies will grow at an 8.5% rate in 2022, although that estimate was compiled by FactSet prior to the war in Ukraine and is subject to revision. 

The availability of attractive stocks ebbs and flows with time. Attractive stocks tend to be plentiful during some periods, but scarce in others. Today’s stock market offers us little that passes our conservative investment screen on good earnings prospects and reasonable valuations, among other criteria. Valuations are still higher than desirable. Earnings growth prospects are increasingly being challenged. Selectivity in stock picking therefore remains important, as does copious amounts of patience. 

On the fixed income side, after hitting peak prices recently, bond prices have come down considerably as yields have gone up in anticipation of the Fed’s interest rate increases. Lower bond prices and higher yields have created an opportunity for income-focused investors to add new money to their fixed income positions, although the fixed income space is not where we should expect outsized growth or significant protection against rising inflation.

The Russia/Ukraine conflict will unfold with greater clarity in the coming days and weeks. In the meantime, we will remain focused on long-term growth, balanced with risk management. 

V. Henry Astarjian

Disclosures: Waterstone Advisors, LLC is a Massachusetts registered investment advisor. Registration with securities authorities does not imply a certain level of skill or training. Investing carries risk of loss, including loss of principal. The information and data presented in this note have been compiled from publicly available sources that are believed to be reliable. However, their accuracy is not guaranteed. Waterstone Advisors LLC does not guarantee the performance of the securities or strategies discussed or analyzed in this note. An investment in these securities or strategies may result in complete loss of principal. For additional information and disclosures, please see our ADV Part 2 (the “Firm Brochure”) in the Our Approach page of our website at  www.waterstoneadvisorsllc.com , or contact us at 978-828-2188.