War in Ukraine

Like many others, we were somewhat surprised when Russia launched its military invasion of Ukraine. We believed, incorrectly, that Putin had already maneuvered Europe into the position he desired, i.e., driving oil prices up (to around $90 a barrel which looks cheap today) and getting a reasonable hearing on his security concerns regarding the expansion of NATO. Instead, Putin chose an invasion that quickly proved messy because of the strong resistance of the Ukrainian military and lack of preparation by the Russian army for this type of fight.

Having been embarrassed by his army’s early miscues, Putin chose to escalate the conflict significantly. He seems content to destroy the infrastructure of Ukraine and kill innocent civilians and, in the process, eliminate a productive and important contributor to certain parts of the world economy. In doing so, he has also decimated his own financial system, or at least that portion of the system with ties to the West. With the western countries having frozen a great deal of the Russian assets held outside Russia, Putin is reliant on continued purchases of Russian energy by Europe and the trade and financial support of China. This is hardly a solid foundation on which to finance a war or the potential future occupation of a relatively large country.

Short Term Implications

Oil prices are likely to go higher as none of the non-Russian producers have stepped up with more production. Adding further pressure is the fact that many shippers and refiners simply do not want to handle Russian oil, not only because of the reputational risk but also the real financial risk that financiers and ports may simply refuse to finance it or unload it.

The only two possible swing producers have been foiled by Biden Administration action. Saudi Arabia is not about to help us out while we are trying to negotiate a new nuclear deal with its archrival Iran. US producers are leery of ramping up investment and production because stated Administration policy is anti-fossil fuel. Despite having spent the last fifty years (since the oil embargo of 1973) working to achieve domestic energy independence, we have simply walked away from that achievement as if it we could eliminate fossil fuels tomorrow. Even the Saudis understand that fossil fuels are not in our long-term future but the transition to alternatives is going to take a long time, given the extent of our current needs and uses.

Speaking of going higher, inflation is likely to continue its rapid rise, driven by higher energy costs, rising wages and higher real estate prices. We have previously noted that we expected the US economy to grow more slowly this year as the massive government stimulus of the last two years is now gone. Add in the interest rate increases by the Federal Reserve as it starts its battle against inflation, and the uncertainties associated with war in Ukraine, and you have the ingredients for a slow growth, high inflation combination. In the 1970s we called it stagflation.

Long Term Implications

We have long been fans of ensuring that our clients have investment exposure to economies other than the US. This view was mostly about taking advantage of a full set of investment opportunities. But two assumptions were key to accessing that opportunity set. They were: (1) the world was largely at peace, at least relative to a longer span of history and (2) globalization of production and consumption gave rise to a great many new opportunities, particularly in developing countries, not to mention the exporting of deflation to importing countries. Unfortunately, these assumptions may no longer be true. The unprovoked attack by Russia on a neighboring sovereign nation harks back to the beginning of WWII. Even if the conflict is contained, the fact that this type of attack is now a possibility makes the peace assumption difficult to make.

We saw globalization begin to break down in the US/China trade negotiations under former President Trump. Just as Trump was pushing his America First agenda, so was President Xi planning to turn China more inward and toward greater self-sufficiency. Unfortunately, relations with China have not improved at all under the current administration and, even worse, Russia and China economic ties have improved, making it easier for Russia to evade some of the Ukraine-related sanctions and setting the stage for more strategic cooperation.

With globalization now on the downswing, we can add another log to the inflation fire. Without the free movement of goods, services and capital across countries, production costs are likely to rise and the profitability of many businesses will suffer. The supply chain issues we experienced due to COVID may be replaced by safer supply chains that will undoubtedly be more expensive.

A Couple of Positive Notes

We are quickly moving into the endemic COVID period, in which full reopening to group activities and travel is likely to continue. With high vaccination rates and effective new therapies, we expect to see a boost in economic activity that will partially offset some of the negative forces we outlined above. The fight against COVID these past two years has spawned a great deal of innovation in the technology and health care sectors. On the technology side, we believe that many more workers will be able to achieve the win-win of better productivity and more flexibility in their schedules. The speed with which the health care system responded to COVID will also spawn new care and treatment models as well as accelerating the already rapid pace of medical innovation.

Investment Implications

Late last year, we were cautious about committing new cash for clients because of the high valuation level of the stock market. While that caution proved to be warranted, it has been replaced with a new caution that the investing backdrop of the last few decades (peace, globalization, low inflation and low interest rates) is now under question. We are optimists by nature but the investing environment may be changing materially. What has not changed is that, over time, stocks rise based on earnings growth. While that growth may be more challenging in the short run, innovation is alive and well as COVID demonstrated. We will continue to diligently assess the changing environment, guided by our clients’ long term investment objectives.