What is it good for? Absolutely nothing. The conflict in Ukraine reached a new level of absurdity overnight. Russian tanks rolled across the border after Vladimir Putin’s teleconference in Moscow-- a full scale invasion of its neighbor and sister country is underway. Though Putin suggests he has no interest in occupying Ukraine, it is his full intention to rid the country of its Western sympathizing government and establish a new regime in its place (it is safe to say one without a NATO lean). For all of the rhetoric between Moscow and the West over the past several weeks we have finally arrived at our first real military flashpoint. What happens next will have significant ramifications for markets and American foreign policy going forward. Our job is the former; we will leave the latter to the politicos.
From a portfolio management perspective, positioning is critical before a crisis unfolds. Our tactical models have been heavily invested in cash since late last year. The catalyst for this was largely a function of valuations in equities. We upgraded our price objective for the S&P 500 twice last year after our initial target of 4450 was released and reached our final price target of 4800 at the end of last year. The market hovered around 4800 for a period of weeks during December and the start of this year, but markets (stocks, bonds, REIT’s, etc…) encountered significant selling pressure as the Fed pivoted from what appeared to be a moderate pace of interest rate hikes toward a more aggressive approach. The objective is to tamp down the impact of near-term inflationary pressures and combat rising longer term inflation expectations. Cash became the haven of choice as long duration US treasuries (typically a source of stability during periods of financial uncertainty) sold off in tandem with stocks. Importantly, the economic backdrop in the US is not deteriorating at this time, but rising interest rates will certainly crimp economic output to a certain extent later in the year. The economic picture among other major economies is much the same with the exception of Germany, which will likely endure a shallow covid-related recession. As such a severe economic collapse on a global or domestic level is not our base case-- more to come on the economic front next week in our coverage of the monthly nonfarm payrolls report. Enter Russia.
Conflict inherently stokes the flames of inflation, which is already running hot today. The prospect of additional global supply chain constraints and higher commodity prices certainly presents unique challenges for consumer driven economies in the current environment. Russian intrigues along the Ukrainian border have driven the prices of various commodities higher year to date—perhaps most notably in the energy complex. Oil and gas approaching $100/ bbl and $5/mcf, respectively, in and of themselves are something central banks must contend with in their domestic economies. While prices at these levels are certainly a windfall for producer countries, the dynamics underpinning the present inflationary backdrop provide Russia (i.e. Mr. Putin) with a significant amount of geopolitical leverage as well. Putin wishes to reestablish Russia’s sphere of influence and he is keenly interested in the domestic politics of his neighbors. Thus, Ukraine is an easy (and convenient) target. Our expectations at the beginning of 2022 centered around the likelihood of a minor incursion into Ukraine; a full-scale military operation seemed an outlier, so long as Russia remained relatively unprovoked. US sanctions regarding the Nord Stream 2 project altered the dialogue between Putin and the West; within hours of President Biden’s announced sanctions Russia began to invade Ukraine.
We will be keeping a close eye on the PMI’s and other economic readings coming out of Europe and Asia in the coming days and weeks. The situation in Ukraine is quite fluid, so we will be watching for imminent economic impacts in the region and beyond. The pendulum is certainly swinging from one end of the risk spectrum to the other with respect to risk assets and this process usually precipitates inefficiencies/ opportunities within financial markets. Of course, the risk adjustment can be tricky and recession risks must remain contained. So, as long as the economics support the fundamentals, we will be looking to capitalize on various opportunities within risk assets.
Market Outlook: Neutral USD, Neutral Duration, Neutral Equities