Mark D. Troutman, PhD, CFP®, Director of Financial Planning
The famous baseball coach Yogi Berra once famously observed that “…It’s tough to make predictions, especially about the future.” Yet, sound investing requires combining a fact-based view of the future with reasonable assumptions about essential information that is needed to make fully formed decisions.
Furthermore, sound investing requires the humility to question widely accepted assumptions and identify unknown but necessary facts. As former Secretary of Defense Don Rumsfeld once said, “you don’t know, what you don’t know”. Finally, and perhaps above all, when new information appears and it’s clear that the facts have changed, it’s critical that you change your view and pivot accordingly.
The crisis in Europe is truly different and navigating it requires all of the facets of sound investing cited above. Russia’s invasion of Ukraine has thrown financial markets into disarray, and by all measures, the outcome is highly uncertain.
In situations like this, i.e., when uncertainty is high and predicting what happens next is challenging, it is helpful to consider a range of possible outcomes and to assign probabilities to those outcomes. This exercise helps us identify what is known and unknown, and it helps us pivot in the right direction with confidence, once we are able to clarify and combine unknown information with known information.
What appears below are a range of scenarios and outcomes. Some are very dangerous but unlikely and some are less dangerous and more likely, and are importantly based on the facts presently at hand.
These scenarios come to us from national security professionals with whom I have worked with in the past, and from whom seem to have made the right calls early on. I’ve interpreted these scenarios with my fellow colleagues in the field of economics to assess the macroeconomic landscape both in the immediate term, and over the long run.
First, Ukrainian forces might be able to extend their early successes and reach a standstill, potentially leading to a Russian withdrawal. This outcome, however, seems very unlikely given the depth and breadth of Russia’s military forces in comparison to Ukrainian forces. History tells us that such an outcome is possible but only with outside support, which the US and Europe are providing to Ukraine, albeit in a very risk averse manner i.e., support thus far, has come in the form of economic sanctions, not troops on the ground or the enforcement of a no-fly zone. Even if this ideal scenario comes true, i.e., Ukrainian forces win the war, both Europe and the larger world would be less secure. Such an uncertainty might lead investors to adopt a more conservative investment posture.
A second and more likely outcome is a grinding campaign by Russian forces that results in a replacement of the Ukrainian government by a pro-Russia puppet regime. Another possibility involves a negotiated settlement whereby Ukraine continues as a state, in part or whole, with a form of Finland-like neutrality. In any case, we can expect continued Ukrainian resistance coupled extreme brutality brought upon them as Russian forces seek to consolidate their current gains. This crisis seems destined to drag on for longer than any of us would like, likely continuing the volatility of late, while bringing about the risk of lower asset prices until the crisis has concluded.
If Ukraine successfully fights back, such setbacks would likely lead to political unrest in Russia and greater uncertainty for the markets in general. Ukraine and Russia account for about thirty percent of world wheat output. The Economist points out that Russia is the source of ten percent of the world’s oil, 24% of world natural gas, and is a major supplier of basic industrial materials such as nickel and more advanced materials critical to high technology manufacturing.
The world can replace these basic commodities, but the adjustments will be costly and painful, and they will not be replaced in the short run. In short, even the best of outcomes, will not come with a cost and negative implications for the economy.
A third and immensely more dangerous set of outcomes, involves direct clashes between NATO forces and Russian forces. While western governments are seeking to avoid such an outcome, Russia’s provocative behavior raises the risks of accidental contact, or worse, direct military contact that leads to escalation. In fact, just this past weekend, Russia bombed a Ukrainian military base that just 15 miles from the Poland border, killing 35 people and injuring as many as 100 more. This is undoubtedly too close for comfort.
Moreover, Russia’s reckless behavior around Ukrainian nuclear power facilities risks radiation discharges and introduces multiple hazards to greater Europe. A radiation discharge could warrant the presence of US and European response teams to assist in clean up, thereby increasing the risk of direct clashes between Russian and NATO forces on Ukrainian soil.
A few conclusions clearly flow from the facts at hand:
One, the Russian invasion of Ukraine, may only seek to further ignite inflation that sits at a 40 year high, pushing out even further the timeframe in which inflation will subside. By all measures, it is likely that high inflation will persist at least through 2022 before it cools. Moreover, there is the real possibility that inflation might be permanently higher, even after this military crisis subsides.
Two, business conditions have entered a new period of uncertainty, and this is particularly evident given supply chain disruptions and the need for physical security of supply chains. Companies will respond by seeking more secure and reliable sources for materials, intermediate inputs, and final production. This is positive development in the long run but hereto, it does not come without costs in the short run. These costs manifest themselves in the form lower corporate profits, while the uncertainty around future profits implies lower price-to-earnings multiples. In aggregate, lower asset prices may be the end result.
Third, expect western governments to invest more in defense security. I attended a recent defense sector conference at which the Department of Defense Chief Financial Officer stated that the pending defense budget bill on its way to the President for signature, contains a 5.7% increase in the DoD’s topline. Germany, long seeking to minimize defense spending, announced a greater than $100B investment in its defense. Companies that have provided standout capability to the present crisis such as Lockheed, and Raytheon (Stinger and Javelin missiles), and European manufacturers SAAB (Sweden), Thales (France), MBDA (Multinational Europe) and Bakar (Turkey) will likely be looked to for innovation in the days that follow.
I opened with humor and seek to close what might be a dark commentary with wisdom. The saying “…keep calm and carry on…” which was common in the UK during the dark days of the World War II, seems to be a good mindset given the set of circumstances in front of us.
Kirk and I are calm. We have mapped out a range of scenarios and outcomes as discussed above. We are vigilantly monitoring short-term developments and we are prepared to adopt a more defensive investment posture, if warranted.
At the same time, we are opportunistically focused on uncovering rewarding investment opportunities for long-term investors. While there is undoubtedly more volatility to come in the near term, in the years ahead we will look back on this time as an opportunity to buy quality assets at depressed prices.
We pray for peace and count it a privilege that you allow us to partner with you during these uncertain times. ■
