From an investment point of view, the war has resulted in two sets of outcomes: first, the company- and currency-specific impact on individual assets, and second, the wider consequences for the global economy – the latter perhaps being of greater interest to investors.
COMMODITY PRICES AND INFLATION
In our view, the key financial impact of the war on the rest of the world has been its effect on commodity prices and, in turn, global inflation.
A month before the invasion, Brent oil was trading below US$90 per barrel, but only a few days afterwards, it peaked more than 40% higher at US$129. Although the price subsequently fell, we’re now paying around 20% more for crude oil. Russia used to account for around 11% of global petroleum supply and while most of this oil has continued to flow, two new problems have arisen:
- Existing buyers of Russian oil and gas in many countries have chosen to source their supply elsewhere
- New buyers are typically more geographically complicated to deliver to.
The supply chains of Russian oil and gas were set up to channel these commodities to Europe, mostly via pipeline, and European buyers don’t have the infrastructure to rapidly change their supply source. Equally, for Russia, while new buyers have been found in Asia and elsewhere, the supply chains aren’t optimised to deliver to these countries, so there are extra costs in getting the product to market.
Before the conflict, Ukraine was a major global supplier of wheat and sunflower oil. With the country now at war, production is much lower, lifting global prices. Wheat prices spiked 63% in the days following the invasion and have now settled at 23% above their 23 February levels, while sunflower oil and coal are now around 40% and 60% higher respectively.
Under ‘normal’ circumstances, such price jumps would cause pain globally. However, they also came at a very inopportune time for central bankers. By February, the prices of many commodities were already well above their pre-pandemic levels and inflation was becoming increasingly problematic. In many ways, the Ukraine war was the proverbial straw that broke the camel’s back.
By late 2021, we thought that the US Federal Reserve (the Fed) was behind the curve in setting interest rates and we expected rate hikes in 2022 despite Fed guidance to the contrary. However, the increased inflationary pressure resulting from the conflict means that the Fed and other central banks have needed to raise rates both further and faster than before in order to tame inflation. This in turn means that the probability of a global recession over the next two years is much higher than the market was previously pricing in.
RISK MANAGEMENT
What can investors learn from all this? In our view, one key reminder is that unexpected, low-probability events can and do take place. Importantly, they can create ‘tipping points’ and consequently have large knock-on effects on asset prices that one may have thought had little or nothing to do with the original event. Appropriate risk management and portfolio diversification are therefore vital.
It’s human nature to focus on what will probably happen. Portfolio managers also need to understand what might happen and be prepared for such events even if they’re not the base case. The current situation should remind investors that the future is just too complex to predict accurately and consistently. Accordingly, prudent investors should position portfolios to be robust in the face of a variety of outcomes. Particularly bold views can work out well – but they can also result in severe permanent capital loss.
When one sees clouds building – as they did with US inflation in mid-2021 – you don’t know if it will rain, but you should at least pack a raincoat. At Sanlam Private Wealth, we were ensuring that our clients’ portfolios could handle inflationary pressure well in advance of it becoming a significant problem.
GEOGRAPHIC DIVERSIFICATION
At a stock-picking level, the most obvious lesson is to remain alert to your underlying geographic exposure. No matter how attractively priced stocks in a particular country might be, they’ll provide little protection if you can’t get your money out due to sanctions. When events such as the Ukraine war occur, geographic diversification is more important than industry diversification.
Sometimes one can be right, but for the wrong reason. Before the crisis, we viewed the energy market as being tight given underinvestment in supply and recovering demand. The conflict exacerbated this, lifting the price of non-Russian energy companies. The lesson here is to be aware of how close any situation is to an extreme – be this valuation of stocks or bonds, the supply/demand balance for a commodity, a government’s finances or an industry about to disrupt or be disrupted. The more extended the situation, the greater the potential impact of an event.
Mindful of these lessons, at Sanlam Private Wealth we will always strive to effectively balance risk and reward in the management of our clients’ money – by diversifying appropriately, remaining humble and being ready to take advantage of opportunities when they arise.
