Thursday February 24^th will go down in the history books as the day when something that was unthinkable months before actually took place – a second invasion of Ukraine by Russia in less than a decade. There was a sliver of hope, as we discussed last week, that an actual incursion could be averted.  Vladimir Putin had different plans and we woke up to the terrifying images of war. Investors are once again being forced to reconcile the previously unthinkable and the consequences for Ukrainians, the world economy and their own portfolios.

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The reproachable action taken by Russia is going to be referred to in financial circles as a “black swan” event, which means it is something that carried a near-zero probability in the expectations of market participants. To be honest, there have been few really true black swans over the years. The attacks on the US on September 11, 2001, were definitely in the category. The pandemic was definitely not in anyone’s one-year forecasts set in 2019, but we knew of the COVID-19 virus before we shut the world down in March 2020. We just didn’t know it would get that bad. Ditto for Ukraine. We have been talking about the risk of a Russian invasion for weeks; but now that it has happened, there is definitely a different feeling.

 

In our message on Thursday, we wanted to emphasize the importance of focusing on the long-term and how the best way to deal with these types of events is to have a disciplined asset allocation strategy, regular review of one’s financial situation and risk tolerance, and a solid financial plan. History has shown that geopolitical events will have short-term implications, but often have little to no medium-term effects. I believe the same will hold true this time around, but there are some ancillary effects that could arise.

 

The invasion of Ukraine reveals the risk in attempting to achieve certain policy initiatives without giving thought to risks unrelated to those initiatives. For years we have faced the reality of climate change and the need for a shift in how we power our lives. There has been a strong adoption of alternative energy sources, however, some policies were adopted as though we could simply flip a switch from fossil fuels. Whether it was standing back from the development of natural gas pipelines or the development of liquified natural gas infrastructure, it is now clear that an opportunity to provide Europe with an alternative source of energy to what comes out of Russia has been wasted.

 

Some may argue that the cost of taking an accelerated approach away from traditional energy is still small relative to the costs from climate change and that may indeed turn out to be true. Yet, it really depends on how we measure cost.  A very dangerous precedent has taken place with the two invasions of Ukraine and expansion of Russia’s influence and the introduction of instability in Europe could have a negative impact on business and consumer confidence in the region. Natural gas prices were already elevated before the conflict, but now shortages could get worse, sending prices higher.  Keep in mind that gas is not only used as a heating source, but also goes into electrical generation and is used in the production of certain fertilizers.

 

 

When news of Russia’s movement into Ukraine broke, so did Brent crude oil futures – right through US$100 a barrel. Some analysts are suggesting that this move could take us to $150 or higher. The risk of a continued rise to levels not seen since 2008 has also been put forward as a reason why the US and its allies did not impose sanctions on Russian oil exports. Reduced output from Russia would exacerbate an already tight supply-demand situation and pressure prices higher. The same holds true for targeting aluminum exports. Futures had edged above $3,000 per metric ton late in October of last year and then retreated to close to $2,500. They have since broken above $3,400 – well above the highs seen in 2008.

 

If oil prices move higher simply because of stronger demand, then this is not a major concern. When this takes place because of supply and we are talking about an implicit tax and, like most taxes, an increase will typically slow economic activity. All things being equal, slower growth will result in slower corporate revenue growth, reduced personal income growth (if employment starts to falter) and weaker government receipts. With fiscal deficits elevated from the pandemic, this is a major problem, and it leaves governments with even less wiggle room on things like climate-focused initiatives.

 

Keep in mind that we are also in a mid-term election year in the US and the population will tend to vote with its pocketbook. If the economy is solid, incumbent parties stand a better of chance of holding seats. If not, you tend to get a turnover. If we do not get a de-escalation to the Ukraine situation soon and energy prices remain elevated, then get used to hearing more economists talking about “stagflation” and if growth really does falter, Democrats could easily lose both House and Senate in November. Losing Congressional seats in a mid-term is commonplace for new administrations, but a deadlock could push off needed economic stimulus and we are back to the growth story.

 

Thinking about the potential long-term consequences from Ukraine, whether we are talking about energy or geopolitics may feel like forecasting the weather inside a tornado, but it is useful in shaping our views of the economy and markets. That said, the long-term direction of stocks has tended to be less sensitive to even major shifts in these key areas. By the time you read this commentary, there will have been even more change in the landscape. Just look at what happened on Thursday, when the TSX went from almost a 350-point loss to a gain of about 17 points. 

 

Events are going to be fluid in the days and weeks ahead. There will be temptations at time to get out of risk and there will be days when you feel it’s time to through all the eggs into the equity basket. Our advice is to ignore both temptations and focus on strategy. This is why we have maintained some cash in the portfolios so that there is room to move equity exposure back up to long-term targets when there is more clarity. I will leave you with one final comment on the need for a long-term focus.  The chart below shows the 10-year percentage changes in the TSX index since the end of WWII.

 

We think of long-term as anything close to 10 years or beyond, so this is a useful reference when looking at equity performance. As you can see, there have been only a few times since the war when there was a negative 10-year change in the index. Now, this doesn’t include dividend reinvestment. If we did, then the negatives would disappear except for maybe 1947. The last time there was a minus sign in front of the 10-year change in the TSX was in March 2020. It remained negative for a very short period of time and, while I am not going to say that incidents in Europe cannot produce another negative 10-year result, it is what happens after that is more important.

 

On behalf of the Pyle Group, have a wonderful weekend.

Andrew

 

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