Market Overview
Gunning for returns
(Note: After this newsletter’s deadline, the Polish government announced that a Russian-made missile struck Przewodów, a village near the Ukrainian border, killing two. Initial reports suggest that this was an inadvertent event rather than an intentional attack. Still, it appears that Russia’s invasion of Ukraine has resulted in loss of life in Poland, a NATO and European Union member. The following column was written as if this were a hypothetical exercise; it is no longer hypothetical.)
For now, let’s go on the assumption that the Russian-Ukraine war spills over into at least one other European nation. It could be an accidental incursion by a small unit that thought they were still in the war zone but actually ventured over into Poland, Slovakia, Hungary, Romania or Moldova. (Then again, let’s scratch Moldova off the list – it’s poor, politically divided into two conflicting mini-states and is not a member of the European Union or NATO. The others are all in both the political and defense coalitions.) Maybe there’s fallout from a radiological “dirty” bomb or a low-yield battlefield nuke that the winds take into the heart of Europe. Best case, none of this actually happens. But planning for the best case isn’t the wisest course.
How do you make sure your portfolio is at least as well protected as the Western alliance?
Inflationary surge
Frankly, we need to keep the present rate of inflation in perspective. Yes, it’s higher now in the U.S. than it has been in a long time, but – if you look at either American history or the current state of the world’s economy – it’s not nearly as bad as what’s being seen and felt in other parts of the world. In fact, inflation in the U.S. may have already passed its peak. That’s not to minimize anyone’s pain at the pump or in the checkout lane, but it’s not driving masses of people to desperation. Given the choice between the hopeless job searches of a recession and the current surge in the cost of living – well, pick your poison. (Incumbent politicians will pick recession every time. Twenty million Americans could be thrown out of work, but 330 million would pay more for groceries.)
Of course, if the conflict in Ukraine escalates, all bets are off.
War can affect a nation’s economic health in very direct ways. There is never enough oil for a wartime military, so fuel for civilian uses might be in short supply. War also calls for the redeployment of production facilities from civilian to military needs. The U.S. economy, driven as it is by consumer demand, would see supply shortages of household products, further driving up the cost of living.
War further causes more public expenditure. So, interest rates will go up. They’d go up anyway just to tamp down inflation but, if you’re uncomfortable with the budget deficit today, wait until we gear up to support our allies in Europe. Whether or not we actually put boots on the ground, we’d still be providing “loans” or “guarantees” for the purchase of arms and materiel for the combatants.
None of this, though, would be a permanent fixture. During the first six months of World War Two, prices rose at an annualized rate of 10.3%, according to historian Christopher J. Tassava. But then wage and price controls were put in place and, as a result, inflation returned to about 3.5% per year for the duration of the war – but there was no guarantee you could actually acquire the goods you could afford to purchase. As soon as these controls ended in April 1946, inflation surged to 28.0% per year before settling down.
High inflation correlates more with demand surges than with wars. But when the shooting starts, according to a recent White House blog post, you can expect the population as a whole to go on a hoarding spree in anticipation of shortages or rationing.
The response
Regardless of how long it lasts, though, higher inflation would be almost inevitable in this scenario.
The first thing to consider is that it might be time to move some money out of stocks and into bonds. You might want to consider Treasury Inflation Protected Securities, or TIPS, which are available in 5-, 10- or 30-year tenors.
Still, there’s no reason to rush to rebalance your portfolio. The S&P 500 holds up well under conditions of both war and inflation. At such times as these, many smart investors change their strategy from buying growth to buying value – that is, to stocks that pay out more in dividends.
Sector rotation might also be in order. Acquiring shares in defense contractors might be a smart move, as well as shares of energy companies, particularly those with natural gas exposure. And bear in mind that, once the guns fall silent, much of the world will have come to terms with the danger of not being energy-independent. While oil and gas companies might be good short-term plays, a lot of long-term money is flowing into energy transition companies that would make petroleum-importing companies more reliant on wind, solar, and hydro, and less so on fossil fuels. Also, we’re all finding out together how critical logistics are. Freight shippers, the technology companies they rely on, and other supply-chain plays are having a moment.
And of course, interest rates will keep going up as long as prices do. It’s time to consider, if you haven’t already, investing in commercial banks and other lenders. Business Insider has an interesting article that names some specific companies related to all these sector-specific themes.
Real estate investment trusts have historically been seen as inflation hedges, but that hasn’t worked well in the current environment. At the moment, though, REITs are cheap and might be worth a look.
Short-term pain, long-term planning
These are just ideas. We’re not even sure of the likelihood of the scenario we set up. Consider this a tabletop exercise.
Even so, we wouldn’t bet against a wider European war once Spring 2023 thaws out the battlefields across Ukraine.
But as we return you to reality now, perhaps your first call ought to be to a qualified financial professional to guide your decisions given this scenario or any number of others.
